Don’t forget to use IRAs as part of your retirement planning strategy

Written by Andrea Solana, CFP™

An important and often discussed ingredient to a successful investment experience as a US person living in the UK includes ensuring your investments are tax-efficient from a US and UK perspective.  When you are a US person paying tax in the UK, it is important to look closely at the structure of both onshore and offshore assets.  Where assets are tax transparent to an individual (for example, an individual or joint account or an Individual Savings Account (ISA) you need to make sure that investments don’t fall afoul of the US Passive Foreign Investment Company (PFIC) and UK Offshore Income Gains (OIG) rules to mitigate any unnecessary and disadvantageous tax charges.

Another important ingredient to having a successful investment experience includes taking advantage of various recognised US and UK tax wrapped vehicles that can provide tax deferral opportunities as well as offer additional freedoms on investment selection.  Taking advantage of different savings opportunities will allow you to build assets in different tax buckets (i.e. some taxable, tax deferred and potentially tax-exempt assets) during your working life which will provide for flexibility around how you eventually decide to drawdown your savings in retirement.

Within this context, a lot of attention is often paid around opportunities to save within UK pension vehicles and things a US person needs to be aware of with respect to reporting UK pensions properly from a US tax perspective.  Less time is often paid around the opportunities that exist to save within US Individual Retirement Accounts (IRAs) which are also recognised in the UK.  Provided a US person is still deemed to have US sourced earned income during the tax year (which is generally the case where individuals claim foreign tax credits or earn income above the foreign earned income exclusion amounts), opportunities to contribute to US IRAs often exist through a Traditional IRA or Roth IRA and in very certain self-employment circumstances a SEP IRA (which isn’t addressed in this article).

The benefits of building IRA savings

Taking advantage of opportunities to contribute to an IRA play a part in building out comprehensive retirement plans regardless of whether your planned retirement is in the US or the UK.  As a reminder, a Traditional IRA (where income thresholds are not exceeded) offers tax relief on contributions and tax deferred growth whilst funds remain within the tax wrapper.  A Roth IRA on the other hand, offers no tax relief on contributions but provides tax exempt growth and tax-free qualified distributions.  Each year where you have relevant sourced earned income, up to $6,500 can be contributed into one of these plans (an additional catch-up contribution of $1,000 is available for those aged 50 or older) which means that consistent annual contributions, and investment growth, over time can accumulate into meaningful retirement balances that supplement your broader investment strategy.  The allowability and deductibility of any contributions are determined based on an individual’s US filing status and subject to income limitations.  For example, to contribute directly to a Roth IRA a single tax filer must have a modified adjusted gross income (MAGI) of less than $153,000 and a married filing jointly tax filer must have a MAGI of less than $228,000 in 2023.  A married filing separately tax filer must have a MAGI of less than $10,000.

It should be noted that there are no upper income limitations should an individual seek to make a non-deductible Traditional IRA contribution in a given year.  This means that a contribution can be made with no tax relief received but earnings on the contribution will grow tax deferred.  This original non-deductible contribution creates an after-tax basis within the plan meaning only the earnings portion of the eventual distribution will be subject to income tax in the future.  This is generally a more favourable outcome than a scenario where a UK excess pension contribution is above an individual’s annual allowance and ends up being taxable income at contribution and again at distribution in the UK.

Where an individual is unable to make direct Roth IRA contributions due to income levels and also does not have other existing IRA balances, an opportunity to make ‘backdoor’ Roth IRA contributions arises.  To do this, an individual would make a current year non-deductible Traditional IRA contribution of say $6,500 and immediately convert the balance over to a Roth IRA via a Roth IRA conversion.  As the original contribution did not receive tax relief, the conversion does not attract additional income tax and the funds end up in the Roth IRA as though you were able to make the contribution directly.  Hence the term ‘backdoor’ Roth IRA contribution.  The benefit of getting funds into the Roth IRA is the fact that money held within this type of plan will be considered tax exempt provided qualified distributions are made in the future.

Regardless of whether savings are built up within a Traditional IRA or a Roth IRA, given the fact that US pensions are recognised under the US/UK tax treaty, it is important to also remember that you do not have to be concerned about whether underlying investments are considered PFICs or OIGs which generally gives you more flexibility around investment choice compared with unwrapped taxable assets.  Additionally, IRAs do not attract additional tax information reporting such as FBAR, Form 8938 or Form 3520 filings as is generally required for UK pensions or other assets held outside of the US.

IRA treatment at drawdown

When it comes to retirement and the drawdown phase of your life, assets held within IRA plans are generally accessible for qualified distributions from age 59.5 and can be drawn down flexibly based on individual needs and circumstances.  Whilst Traditional IRAs attract a required minimum distribution (RMD), the RMD does not begin until age 73 and is based on life expectancy.

Provided you distribute your pensions as periodic payments (as opposed to a single lump sum) the US/UK tax treaty states that the country of residence at the time of distribution has the primary right of taxation to tax distributions.  So, generally if you live in the UK at the time you begin taking periodic distributions, the UK will have primary taxing rights.  However, the UK must exempt from tax any amount of an IRA that the US would otherwise exempt for a US resident.  This means that any funds held in the US pension on a pre-tax basis will generally attract income tax at distribution and any funds held on an after-tax basis within an IRA would not be taxed again at distribution.  In the case of a Roth IRA, qualified distributions would be tax-exempt in the US and the UK.  This makes saving into a Roth IRA about as close to an ISA as you can get for a US person living in the UK.

With respect to Roth IRAs, RMDs are not required at any age.  Given the tax-exempt nature of the Roth IRA, building up a pot of savings within a Roth IRA can help an individual manage their exposure to higher income tax bands each year where taxable and tax deferred savings place you close to the next tax band, but additional sources of liquidity are needed.

Where RMDs must take place but an individual doesn’t need the funds, a qualified longevity annuity contract may be a consideration or there is also an option to direct up to $100,000 per year (adjusted for cost of living each year) to a US qualified charity via a non-taxable distribution from their IRA.  Individuals can also use the charity strategy to satisfy their RMD requirements for a given year and manage their income tax exposure at the same time.

In summary, where US people in the UK are accumulating assets, continue to have earned income and are looking at various structuring opportunities for long-term retirement assets, it is important to consider US pension planning as part of your comprehensive strategy based on specific facts and circumstances.  To explore these options within the context of your individual situation, you should seek advice from a wealth manager and tax adviser who is knowledgeable about cross border wealth planning.

The Legal Stuff

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