In summary, by operation of the U.S.-U.K. Income Tax Treaty, any pension exemption in one country is recognized in the other. For individuals in the U.K. receiving a distribution from a Roth account based in the U.S., that means that the U.K. will honor the tax-free nature of the account, which means zero tax to the HMRC.
However, the default rule is that it's taxable in the U.K. unless and until you affirmatively elect to claim the benefits of the treaty. This is where you need us to avoid 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.
Please note this also creates an opportunity for a U.K. citizen to create an unlimited tax-exempt retirement fund based in the U.S. that can lawfully avoid U.K. taxation. Effectively, this serves as a QROP Loophole. You do not have to be a U.S. citizen to open a Self-Directed Roth IRA. We are one of only 3 law firms in the world that know how to structure this, so don't expect to find someone local that knows. It involves a treaty-based SIPP-to-IRA rollover followed by a tax-free backdoor conversion to a Roth IRA, which effectively makes the entire account exempt from UK tax pursuant to the Reciprocal Pension Exemption in Article 17(1)(b) of the US-UK Income Tax Treaty. Similarly, there is a method by which a UK national could extract a U.S.-based 401(k) or IRA tax-free using a similar strategy.
The general rule is that U.K. tax residents are subject to tax on their worldwide income from any source, including U.S. pensions. 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.K. tax law applies by default unless a taxpayer specifically elects to apply the treaty. If a U.S. taxpayer applies the benefits of a treaty, it supersedes domestic U.K. tax law.
U.S. Roth Accounts
Under domestic U.K. tax law, income within and distributions from a U.S. pension are subject to U.K. 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.K. taxation on distributions from U.S.-based Roth retirement accounts under Article 17, Paragraph 1(b) of the U.S.-U.K. Income Tax Treaty. Furthermore, our firm can take the position that, pursuant to the treaty, there is no U.K. tax on the growth during the accumulation phase.
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 to avoid penalties. Second, it must be accompanied by a full and complete legal explanation of the position. Third, without the legal explanation, the HMRC will likely challenge the position, assess tax on all of the historical gains in the pension, and impose a 100% tax penalty with interest thereon. 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.
Contact Our Firm
Contact our firm today to schedule a free consultation. Our team of international tax attorneys and CPAs can ensure everything is properly reported in accordance with the treaty to lawfully avoid taxation on your Roth retirement accounts.
About the Author
John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English, a graduate of Georgetown University Law Center in Washington DC, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney with offices in New York, Los Angeles, Washington DC, Miami, and Dallas.