nun

Ask your question in the tax section of UK-yankee. There are a lot of the same folks over there, but some tax professionals also post there

US - UK Taxes

Also here is a useful thread from a professional tax site. Take note of Guya's comments. He is probably one the the most knowledgeable US/UK tax professionals around.

TaxProTalk.com • View topic - UK 25% tax free lump sum

But even if we disagree about how the term lump sum is to be interpreted when applying the tax treaty, it seems pretty obvious that if you set up a payment plan for the tax free amount over a number of years it is actually now a periodic payment of UK tax free pension income and so also tax free in the US.

annetteangela

Thanks! All very useful.

scrubbedexpat099

As far as I know there is no US equivalent of a tax free lump sum so why would there be a rule about it?

kodokan

With a defined benefit pension, it's almost always worth NOT taking the lump sum and instead having the larger (usually) index-linked pension instead, absent any personal knowledge about potential limitations of life span.

(I'm basing this on the pension options given to various public sector workers within my family, who've mostly (sadly) gone for the immediacy of the 'ooh, shiny!' lump sum because they have had parents living well into their 90s, but don't appear to be able to do basic probability.)

scrubbedexpat099

It depends and I have not looked into this for maybe 20 years. At that time it was for most people most of the time a good deal to take the cash. General rules are difficult because as you imply it is individual specific.

nun

Maybe some history is required here. Some UK pensions set up before 2006 allowed 100% tax free lump sum withdrawals. It seems that UK citizens with US pensions (which must have qualified for a UK tax exemption on the lump sum) were able to temporarily move to the UK and avoid both US and UK tax on the lump sum withdrawal. So Article 17.2 is to prevent tax avoidance on US pensions by UK citizens, not to eliminate the 25% tax free UK pension sum.

theOAP

Between this site and UKY, it's been a busy week for discussions of pensions and the US/UK Treaty. We've had posts on the taxation of the UK State pension, UK Government pensions, and now once again, lump sum distributions from UK pensions. That's 3 out of 4. I'll get to number 4 in a minute.

The following is from my experience on retiring in the UK with a UK company defined benefit pension. When retiring in the UK, the 2 main alternatives are: 1) max pension, and 2) max cash. Max cash also carries a third consideration: 3) cash (lump) sum amount.

From my records: If the monthly pension payment calculated by taking the max pension amount (no lump sum) was X, the max cash monthly pension (with lump sum) was 85% of X. The lump sum would have equalled 1.9(12 x X), or roughly 2 years worth of max pension payments (X).

Faced with these figures, all of my fellow employees retiring at that time took the lump sum. With only a 15% reduction, and 2 years of pension benefits tax free payable immediately, I don't think anyone seriously considered doing anything else. That seems to be normal for those retiring in the UK.

Being a US Person, not only did I need to consider a possible US tax responsibility on the lump sum, but also an additional problem (#4). Those taking early retirement in the UK from a company via a redundancy programme (also normal practice) usually have Ex-gratia payments (contractual), loss of office payments, and special payments as well. Under UK law, the first £30,000 of those payments (total aggregate) is tax free.

Anyone care to speculate on the US tax treatment of the mandated £30,000 UK tax free treatment on a US return?

My suggestion: each individual must decide how they wish to approach the US tax liability, and they also must decide to what level they're willing to argue their point if the IRS disagrees with their interpretation of the Treaty. There are NO simple, straight forward instructions from the IRS where foreign pensions are involved, and a plethora of contradictory statements.

annetteangela

From what everyone has been saying, it seems to me that taking the lump sum and reduced pension carries quite a high risk of the lump sum being taxed in the US. If I take it spread out over a period of years to avoid that (still not a sure thing) then I might as well take the higher pension instead from the start. With little or no interest being payable on the lump sum if I take it, I think it will be netter to have it as a higher, index-linked pension, which still won't suffer that much income tax because it's less than $10K a year. I've calculated that if I live to be older than 72 I'll fare better financially choosing that route. I'm in good health, so I'm hopeful.
Now I just have to decide what to do about my personal pension, which I can take at any time, but I think I will leave for a few more years. The rules regarding those are now that you can take the whole pot and only be taxed at your current rate on 75% of it - again, this probably does not apply in the US, so maybe it's best to wait until annuity rates recover? Or perhaps that's the one to take over a period of years so that at least the 25% remains tax free.

scrubbedexpat099

I can not see annuity rates improving significantly.

nun

Whether its a good idea from a financial standpoint to take a cash amount or a larger annuity depends of the internal rate of return, how long you live and your other retirement income streams. I've taken both options; cash lump sum from one plan and a larger annuity form another. Most people in the UK will take the cash free 25% and I bet they don't even consider using a present value or annuity calculator when making the choice.

theOAP, the tax free payments "of which you speak" don't sound as if they come from a UK pension plan and so would be "Other Income" and fully taxable by the US.......IMHO. Another good one to think about is a UK pension tax free death benefit, if that's a single payment, is it a lump sum? Taking UK pension payouts of any kind as a series of periodic payments ( the IRS defines those as "Generally, periodic payments are pension or annuity payments made for more than 1 year that are not eligible rollover distributions) firmly places the payments under Article 17.1.....again IMHO

nun

Part of the reasoning in taking a cash payment instead of an annuity is that you get access to your principal and also have the opportunity to get a far higher rate of return on your money by investing it; you aren't limited to saving accounts that have basically 0% interest.

When considering whether to take the annuity or a cash payment did you derive the annuity internal interest rate assuming your actuarial life expectancy? If you do that you usually come out with numbers like 2% or 3%. Annuities are generally very poor from an investment point of view, but they are good for insurance and guaranteed income. Also remember that in the UK you now have more pension options and are not required to buy an annuity with your pension pot.

nun

There's no UK tax on personal pensions when paid to a US resident. You need to be careful when taking pension payments to make them tax efficient and that generally means spreading them out over a number of years to keep your marginal tax as low as possible.

theOAP

I agree, and at the time I included the £30,000 in gross income on the US return. Although it resulted from retirement, (IMHO at the time) it had nothing to do with pensions.

A long discussion with a friendly IRS agent concluded the funds were equivalent to a US severance payment. Of course, this is interpretation since no where is there any direction on the UK payments, anywhere. Being "severance" meant earned income (at the time) which also meant "general limitation" basket for 1116. Enter large amounts of excess foreign tax credits from previous years foreign employment, and two years worth equated to $0 tax due.

I'll now wait for Cook County to come in on this and tell me it was wrong. (Thank goodness it was 10 years ago.)

Again, my point is for each individual situation there may be a different solution to the problem. No "one size (interpretation) fits all".

The payout on death prior to age 65 from a pension fund can be huge, and is again one of those areas causing consternation. The good side is it is no longer the worry of the US Person, since they're dead, but definitely of concern when doing estate planning.

By the way, I did not take the lump sum offer, but went for the "max pension". All my friends were buying a Ferrari or a holiday home in Portugal.

nun

The personal circumstances of taxation is what makes it quite an interesting topic as there are so many variables.

I was thinking about a US citizen receiving a death benefit from a UK pension.

Just to emphasize how the new UK pension rules can be used to eliminate the "25% lump sum" question here is a recent article. You basically keep your money invested and each withdrawal is 25% UK tax free. That is analogous to having a tax free amount invested in an IRA and the tax free portion of any withdrawals are tax free in both the US and the UK under Article 17.1.b. So don't take your UK tax free amount all at once, take it as part of regular withdrawals or payments and I find it hard to see how Article 17.2 is relevant at all.

http://www.thisismoney.co.uk/money/p...evolution.html

annetteangela

The pension I am due to receive next year is a final salary company pension scheme and is index-linked, therefore taking the higher pension will result in the additional amount (over and above what I would have if I take the lower pension and cash lump sum) also being index-linked and therefore I will effectively be receiving interest on it, with no risk. If I take the cash lump sum I risk losing some of it to tax and then I have to find somewhere to invest it where I'll receive a decent return (unless I spend it on a new car ). Getting a reasonable return on it will inevitably entail risk, which I have had enough of over the years.
As for the personal pension, annuity rates have been terrible for years now and I agree with Boiler, they are unlikely to improve in the foreseeable future. I have the death benefit (the value of the plan) written in trust for my kids who are UK citizens and residents, so I can't see a problem with that if I die before taking the benefits. If I do take the cash from that (it's a decent size), I will want the cash because converting it to an annuity will render it pretty insignificant in comparison to the lump sum, especially if I wanted any annual increase.
I really do appreciate all the input in this forum, as it helps me to decide the way forward. Thanks to everyone for your helpful comments and advice.