U.S. Tax Treatment of UK Pension Distributions
by John Anthony Castro, J.D., LL.M.
In summary, U.S. citizens and residents are subject to tax on their worldwide income including UK pensions. However, if you make a proper election on IRS Form 8833 to apply the benefits of the US-UK Income Tax Treaty, any pension exemption in one country is recognized in the other. Therefore, for individuals in the U.S. receiving a UK pension distribution, that means that the U.S. will honor the 25% tax-free lump sum amount, which is formally known in the UK as the Pension Commencement Lump Sum or PCLS for short that allows you to extract the first 25% tax-free. However, the default rule is that it's taxable in the U.S. unless and until you affirmatively elect to claim the benefits of the treaty by attaching IRS Form 8833 to your tax return.
If you do not disclose the treaty position correctly on IRS Form 8833, the IRS will impose both tax and penalties. We offer free, no-cost, no-risk, open-ended consultations. Just contact us so we can chat. You don't have to pay us anything. But it's critical we chat to set you on the right path. We're a transparent and honest law firm; hence, these articles giving away knowledge of the law for free.
Where we add value is planning for the remaining 75% that's not tax-free. We can make it tax-free with a treaty-based qualified SIPP-to-IRA rollover and post-rollover tax-free backdoor conversion to a Roth IRA, which will effectively convert the entire amount into tax-free income.
The general rule is that U.S. tax residents are subject to tax on their worldwide income from any source, including U.K. pension. The good news, however, is that treaties can be utilized to change this general rule.
Whenever U.S. taxpayers are confronted with an international tax issue, they need to know that there are two separate and distinct bodies of law that could potentially apply to their issue. First, there is domestic U.S. tax law; Title 26 of the United States Code, which is known as the Internal Revenue Code. Second, there is international treaty law; the Convention Between the Government on the United States of America and the Government of Great Britain and Northern Ireland for the Avoidance of Double Taxation, which is more commonly known as the U.S.-U.K. Income Tax Treaty. Domestic U.S. tax law applies by default unless a taxpayer specifically elects to apply the treaty by filing IRS Form 8833. If a U.S. taxpayer applies the benefits of a treaty, it supersedes domestic law.
Under domestic U.S. tax law, income within and distributions from a U.K. pension are subject to U.S. taxation just like any other pension income.
Under the U.S.-U.K. Income Tax Treaty, however, there is an opportunity to lawfully avoid U.S. taxation on the 25% Pension Commencement Lump Sum (PCLS) portion under Article 17, Paragraph 1(b) of the U.S.-U.K. Income Tax Treaty. Article 17(1)(b) is referred to as the "reciprocal pension exemption." It basically holds that, if a particular type of pension distribution would be exempt from tax by Country A, then Country B is legally bound to recognize that exemption.
Thus, for example, the UK exempts the first 25% lump withdrawal, so the U.S. is legally obligated to recognize that exemption. Likewise, distributions from a U.S. Roth Individual Retirement Account is exempt from tax in the U.S., so the U.K. is legally obligated to recognize the exemption.
It is important to note that there are highly technical requirements to taking a legal position under an income tax treaty. First, it must absolutely be disclosed on IRS Form 8833 to avoid penalties. Second, it must be accompanied by a full and complete legal explanation of the position. Third, without the legal explanation, the IRS will likely challenge the position, assess tax on all of the historical gains in the pension, and impose a 20% tax penalty with interest thereon. Fourth, if you also engage us to handle the remaining 75% of the fund, we will need to submit documentation to the HMRC to certify U.S. tax residency to exempt the payout from withholding tax.
By having our firm handle the return, you can rest assured there will be no inadvertent errors that could lead to a staggering tax bill and penalties.
The four options for clients to deal with U.S. tax exposure on the 25% Pension Commencement Lump Sum (PCLS) amount are as follows from least costly to most costly as well as from most risk exposure to zero risk exposure:
1. DIY. The do-it-yourself option is always an option. We don’t charge for the initial consultation, so you’re free to use the information and legal explanation to prepare and submit your own U.S. federal income tax return with Form 8833 explaining the legal position. No cost. To download the Form 8833, click here.
2. Tax Return Preparation. You can have our firm handle the return preparation as well as the Form 8833. Having our firm submit the return will put the IRS on notice that you’re represented by our firm, and they’re very well aware of our firm’s well-developed position on this matter. Please watch our law firm’s video on Private Individual Tax Planning by clicking here. The video explains everything about our firm, our process, and our fees, so it’s absolutely critical that you take a minute to watch it.
3. Tax Opinion. The Tax Opinion will serve to legally prevent the IRS from imposing any tax penalties on you for this legal position. The Tax Opinion will also serve to exempt you from all past, present, or future failures to file Form 3520. In other words, the Tax Opinion will apply retroactively to cure all prior non-compliance associated with the pension. The Tax Opinion is a one-time charge of $3500, and, once the Tax Opinion is on file, it’s good for life.
4. Tax Opinion with Indemnity. This option will permanently and perpetually shield you from any and all U.S. tax exposure on your UK Pension. In addition to the Tax Opinion, our firm will fully defend the position at no additional cost if your UK pension ever becomes the subject of an examination. In the highly unlikely event we are unsuccessful in defending the position, our firm has agreed to assume all legal liability for all tax, penalties, and interest. We do this for our clients to demonstrate our confidence in the tax position. The fee for this option is the greater of $3500 or 1% of the fund value.
Our team of international tax attorneys and CPAs can handle the submission of the federal income tax return to ensure everything is properly reported in accordance with the treaty to lawfully avoid taxation on the tax-free lump-sum distribution.