Transatlantic Tax Considerations for UK Pensions

Written by Terence Sivakumar

This blog aims to highlight key considerations for US/UK individuals looking to grow their UK private pension pot ahead of retirement.

While this blog contains a lot of technical details, it should not be relied upon as advice. We always recommend you speak to a qualified tax advisor to ensure you receive advice that takes into account your specific individual circumstances.

How much can I contribute to a UK pension? How does the IRS view these contributions?

Investors can theoretically contribute an unlimited amount to their pensions. However, there are factors which limit the benefits of doing so.

Firstly, tax relief is only given on pension contributions up to an amount of ‘relevant earnings’ for the year – UK employment income and self-employment income. For any investor earning less than £3,600 per year, they can still contribute £3,600 gross.

Secondly, there is an annual allowance of £60,000 for pension contributions, and contributions in excess of that amount are penalised. Contributions in excess of the annual allowance are added to your taxable income for the year, and taxed at the investor’s highest marginal rate.

The annual allowance available for additional rate taxpayers is tapered down £1 for every £2 from £60,000 on adjusted earnings between £260,000 and £360,000 and once adjusted earnings exceed £360,000, the annual allowance is £10,000. The rules on exactly how much can be contributed depends on individual circumstances and, as with all rules, they may change in the future.

Tax relief on contributions in excess of the annual allowance can sometimes be obtained by using any unused annual allowance from the previous three qualifying tax years as long as the individual was a member of a qualified UK registered pension scheme in those earlier years. Any contributions paid for the prior three tax years will be based on the annual allowance limit and tapering rules that applied in each of those relevant years.

US Tax Perspective

Many US taxpayers earning a living in the UK pay more income tax to the HMRC than they would otherwise pay to the IRS. The UK tax paid can be claimed as Foreign Tax Credits (FTCs), and the disparity in tax rates means that US taxpayers often end up with excess FTCs, which can be carried forward for ten years before they expire. Excess FTCs can be used to reduce US taxes on foreign sourced income that isn’t also taxable in the foreign jurisdiction, and contributing to a SIPP can be one way to do this.

SIPP contributions lower the individual’s UK taxable income but are usually not fully off-settable against income taxable in the US (as the US does not always recognise all contributions into UK pensions as tax deductible). So, UK income may receive UK tax relief, but no US tax relief, at which point excess FTCs become useful.

Therefore, SIPP contributions can help align US and UK taxation. The most tax-efficient SIPP contribution from a US perspective is whereby the individual’s UK income is reduced to the point where the UK and US taxes become equivalent. For many investors this may be a difficult calculation, so we would strongly recommend discussing this with a tax advisor.

While SIPP contributions provide an excellent opportunity to use up excess FTCs, they also create ‘tax basis’ in the SIPP for US tax purposes, as the contributions are deemed to be made ‘after-tax’. Any after-tax dollars will not be subject to US tax when later distributed. This can be extremely valuable where an individual decides to retire in the US as opposed to the UK, as will be discussed later in the section on distributions.

How is the growth viewed in both the US and UK?

In addition to up-front tax relief in the UK, investments within a SIPP grow tax-deferred – free of UK capital gains and income tax until the point of distribution.

For US taxpayers however it is not that simple. Sometimes, the way SIPPs are structured means that they can be interpreted to be more akin to the US definition of a foreign grantor trust, rather than a foreign pension. Equally, the IRS has not, as of the time of writing this blog, clearly defined how they view SIPPs, so it remains entirely up to interpretation.

Foreign Grantor Trust

A SIPP may be viewed as a foreign grantor trust for US tax purposes. In this case, the protection offered to the pension under the US/UK Income Tax Treaty (‘the treaty’) will not be applicable. The income and capital gains realised within the SIPP would be taxable on the beneficial owner as they arise similar to a taxable individual account.

Being subject to US income and capital gains tax on the activity within your UK pension will help to build basis in the pension, as you are paying the tax upfront. Equally, your US tax rate on income and gains generated within the plan may be lower than the tax rate applied on future pension distributions – long-term capital gains (on assets held for more than 12 months) and qualified dividends are taxed up to 20%, whereas pension distributions can be taxed at up to 37% federal income tax in the US.

Being taxable on the activity within your SIPP may also allow you to use up any excess FTCs you have generated, however this will be highly dependent on the type of income which has led to the excess FTC position.

This, therefore, may be beneficial to anyone looking to retire back in the US. However, anyone looking to retire in the UK should be mindful of potential double-tax as the US will tax underlying activity as the pension grows, and the UK will continue to tax you on subsequent distributions.

Foreign Pension

If a SIPP is viewed as a foreign pension, the individual may elect under the treaty to defer taxation of growth, or untaxed contributions until the point of distribution. This view of SIPPs would be beneficial for anyone looking to retire in the UK as both jurisdictions will only tax distributions, allowing for transferability of tax credits, and avoiding double-tax issues.

This would also be beneficial for anyone returning to the US who are expecting to be in a lower tax bracket in retirement, as the US income tax exposure on an eventual distribution is likely to be lower than top rates mentioned in the section above.

Where a SIPP is viewed as a foreign pension, investors have more flexibility on investment options and can choose to invest in PFICs, US Mutual Funds, Offshore Funds, etc. as the treaty relief absolves the investor of otherwise complex filing requirements that come with owning those assets directly.

Annual US Reporting Obligations

If a SIPP is viewed as foreign grantor trust, it has an annual informational reporting obligation to the IRS through Forms 3520, and 3520-A, along with income and gains being reported on the personal tax return of the investor.

If a SIPP is viewed as a foreign pension, generally investors custody their SIPP portfolio offshore and therefore have to file a FBAR form annually, and a Form 8938 with their personal tax return, if they breach the respective filing thresholds. Equally, investors may also file Forms 3520 & 3520a annually on a ‘protective’ basis given the lack of clarity provided by the IRS.

Investors should speak with their tax advisors to determine which of these options is relevant to their own personal situation.

What about pension distributions? Surely this is simple?!

In the UK, pension funds can be taken beginning at age 55 (age 57 from April 2028). A pension commencement lump sum up to the lump sum allowance is tax-free. The remainder of the pension will generally be subject to income tax at distribution and can be drawn down in a few ways.

The Transition Away from the Lifetime Allowance

Prior to April 2024, the UK imposed a lifetime allowance on the amount of pension benefits you could accumulate. Any amount over this allowance was subject to a tax surcharge when subsequently distributed. These rules were always considered to be punitive.

The lifetime allowance was abolished in April 2024, and with it, the surcharge on distributions of benefits exceeding the lifetime allowance.

The lifetime allowance was replaced by two new allowances: a lump sum allowance (LSA) and a lump sum and death benefit allowance (LSDBA). The default lump sum allowance is £268,275 (25% of the most recent lifetime allowance) and the default lump sum and death benefit allowance is £1,073,100 (the most recent lifetime allowance). Your LSA and LSDBA may be higher than the stated default amounts if you hold any legacy lifetime allowance protections.

The LSA represents the maximum amount that can be taken tax-fee as a pension commencement lump sum or as a tax-free element of any uncrystallised funds pension lump sum. The LSDBA represents the maximum amount that can be taken tax-free in aggregate in certain instances during the pension owner’s lifetime and on death.

US Income Tax

From the IRS’s perspective, you will most likely have ‘basis’ equal to your contributions by default, and potentially also the growth in your SIPP while you were UK resident if the SIPP has historically been viewed as a foreign grantor trust for US tax purposes. If so, US tax would only be due on the value above your ‘basis’. This would be taxable at your marginal income tax rate.

However, as mentioned previously, if you are suffering full UK tax at your marginal rate on pension distributions., but have near-full basis from a US standpoint, that likely means you would have paid tax twice on the growth of the pension – once in the US as the growth happened, and then again in the UK at the point of distribution.

Alternatively, if the SIPP is viewed as a foreign pension, the taxing point in both the US and UK is deferred to the point of distribution. The UK retains primary taxing rights on regular pension distributions by a UK resident investor under the treaty – with taxes generally collected through PAYE – but the US allows a tax credit for UK taxes paid, thereby reducing or eliminating the double tax exposure.

If an investor ceases to be UK resident ahead of taking distributions, those distributions may fall outside the scope of UK tax entirely. In this case it is also possible to elect to stop UK tax withholding through PAYE on pension distributions. The ability to do this will, of course, depend on the double tax agreement between the UK and the country of residency. Advice should be sought from a tax advisor to understand the relevant liabilities.

US citizens should check with a tax advisor as to whether the tax-free pension commencement lump sum is considered tax-free in the US when distributed. This can sometimes be an area of difference with practitioners.

If it is not considered tax-free by the US, then calculations should be performed to see what the level of ‘basis’ is within the pension, as this will reduce the effective US tax rate on distributions. It is therefore of vital importance to keep records of contributions to UK pensions and any tax that has been deemed to be paid over the years for US tax purposes.

US citizens looking to distribute from their SIPPs should also review their foreign tax credit position as these credits could potentially be used against the US tax liability on distributing the pension commencement lump sum in the UK.

The Legal Stuff

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• The views expressed in this article do not necessarily reflect the views of MASECO as a whole or any part thereof.
• This document is provided for information purposes only and is not intended to be relied upon as a forecast, research or investment advice.
• This document does not constitute a recommendation, offer or solicitation to buy or sell any products or to adopt an investment strategy.

Risk Warnings:

• All investments involve risk and may lose value. The value of your investment can go down depending upon market conditions and you may not get back the original amount invested.
• Your capital is always at risk.
• Fluctuation in currency exchange rates may cause the value of an investment and/or a portfolio to go up or down.

Any impact from the actual or speculative tax changes contained in this document will depend on the individual circumstances of each client and may be subject to change in the future.

• Information about potential tax benefits is based on our understanding of current tax law and practice and may be subject to change. The levels and bases of, and reliefs from, taxation is subject to change.  The tax treatment depends on the individual circumstances of each individual and may be subject to change in the future.

Performance:

• Past performance is not a reliable indicator of future results.
• No assurance or guarantee can be given that any target return will be achieved.

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