How to keep UK pension savings tax efficient in the US

A mixed blessing

UK pensions don’t qualify as retirement plans under US domestic legislation because they are not established in the USA. Despite this, in theory, the current US/UK income tax treaty allows US citizens and residents to claim relief in three ways:

• On certain contributions to plans
• On income and gains within the plan before there is a distribution or benefit
• On amounts drawn from the plan that are UK tax-free

In practice, however, a lack of clarity in the relevant provisions makes applying the treaty relief complicated and subject to interpretation. With SIPPs, for example, while the treaty can protect an individual from US taxation on income and gains in a pension plan, additional reporting obligations for non-US trusts may arise.

In fact, the treaty won’t always benefit US taxpayers. In some cases, it makes sense to waive treaty benefits and include income and gains from a pension scheme, particularly with an employer plan. This can happen when the contributions or the full vested accrued benefit can be added to US taxable income with little or no increase in the resulting tax, for example. Doing so allows the basis to build up in the plan for US tax purposes and the individual to use UK tax credits to offset the increased income. If a taxpayer is transferring funds to a SIPP, they may also choose to forgo the treaty and treat the transfer as taxable in the US (but relieved by foreign tax credits).

In such cases, the amounts in question are taxable only once in the US. They should be tracked to ensure that pension payments at retirement take account of previously taxed income for US purposes.

Taking money out

It’s equally important to take advice before drawing money as it is during the accumulation phase.   After saving over the course of a career, individuals will want to ensure they make the best use of their funds in retirement planning. To do this effectively, they will need to determine the taxable amount of each distribution, the sourcing and character of the distribution, and any offsetting tax credits. They also need to know how to report a UK pension commencement tax-free lump sum and whether amounts tax-exempt in the UK will also be free of tax in the US. 

Reporting

Individuals may need to report the pension on form 8938, FINCEN 114 and in some cases form 3520 (in the case of SIPP’s formed under a deed of Trust).The US reporting along the way is extensive and has severe potential penalties of US$10,000 per form or more. In some cases, such as where a non-employer trust is involved (as is typically the case for a SIPP), penalties may be US$10,000 or up to 5% of the pension’s value, whichever is higher. These punitive penalties exist even when there is no unreported income.

Throughout the tax reporting cycle, taxpayers will need to be able to identify how to report pensions on their tax return on various forms: form 8938, FinCEN form 114 (known as the FBAR), and, if any trust disclosures are needed, on forms 3520 and 3520-A. It may also be necessary if filing a state return or planning a move. 

Advice is particularly important when considering inheritance. If structured correctly, a UK pension plan can be free from UK inheritance tax and offer favourable income tax treatment for distributions to beneficiaries. The same is unlikely to be true for US estate tax, and the issues need careful consideration. Taxpayers expecting any residual UK pension funds to be left for US beneficiaries should consider the tax treatment of plan distributions as part of a wider review of their estate planning.