Lifetime ISA & UK Pension
U.S. Tax Help When You’re An Expat In The U.K. ➥ ISA & UK Pension
Table of contents
Employer and private pensions for American expats in the UK.
Do I need to report my UK pension on my US tax return?
As a US citizen or Green Card Holder with an employer pension in the UK, you may have to report this as a foreign trust. US owners and beneficiaries of foreign trusts face complicated reporting requirements.
Firstly, to qualify for a UK pension, you must live and work in the UK with a valid National Insurance Number.
When do you have to report your UK pension as a foreign trust?
Let’s begin with when you don’t have to file your UK pension as a Foreign Trust.
For employer-provided pensions, whether you have to report your pension as a foreign trust depends on the contributions between the employee and employer. If the employer contributes more than the employee, there are typically no complicated US tax implications.
All you have to do is report the balance of the employer-provided pension on your FBAR and Form 8938 (Statement of Specified Foreign Financial Assets) if you have a Form 8938 filing requirement.
Because the account is considered a qualified retirement plan for US tax purposes, employee contributions and employer contributions invested in the pension along with growth are US tax-exempt.
What if the employee does contribute more?
When the employee contributes more than the employer, complex US tax compliance typically follows. That is unless the pension is contract-based as opposed to trust-based; see below.
For a UK pension to be considered “employer-funded” the majority of the funds flowing into the pension must be from an employer. When that’s not the case, the pension cannot be considered “employer-funded”.
In such a scenario, the pension will then be considered a Foreign Grantor Trust for US tax purposes and will need to be reported to the IRS on Form 3520 and 3520-A.
Consider contributions in full, not annually.
When we compare contributions between employees and employers, we look across the life of the pension, not a single year.
Even if employee contributions were higher in some years, as long as the employer contributed the overall majority since the pension was opened through to the end of the US tax year that’s being filed for, the pension would not need to be filed as a Foreign Grantor Trust.
Contract-based V’s Trust-based pensions.
If your UK pension is contract-based, your pension will not be considered a Foreign Grantor Trust even when your contributions are higher than your employer’s. This means, Forms 3520 and 3520-A do not need to be filed if your UK pension is contract-based.
Another approach…
Another approach is available because of the US-UK Tax Treaty which is sometimes better for US taxpayers.
Even though reporting contributions, employer contributions, and growth on tax returns, there will most likely be no current-year tax due because Foreign Tax Credits could cover the tax. The benefit comes when money is withdrawn from the pension because it will no longer be subject to US taxation as it’s already reported as income.
If I take the 25% lump sum from my UK pension, will the IRS tax it?
Yes, if you decide to take your 25% lump sum tax free from your UK pension, the IRS will consider the total distribution as taxable income. Read more here…
When does a foreign trust become a foreign grantor trust?
As long as the contribution from the employer is higher or equal into the account than personal contributions then you are fine. The Problem occurs when you are putting in more money in than your employer is contributing, making it a Foreign Grantor Trust. In this situation, it would be similar to the treatment of a Self-Invested Pension Plan (SIPP), where you have to file Foreign Grantor Trust Form 3520 and Form 3520-A. Form 3520 reports the existence of the trust and the transactions, while Form 3520-A reports a statement of financial position with a profit and loss statement of the trust.
Assuming it is not a UK pension plan, whatever the income of the trust is, it flows through your tax return. As a UK pension plan, it is covered by the UK-US Tax Treaty and whatever income the trust generates will not flow through your tax return as it is tax exempt.
How and when do I file Form 3520-A?
Form 3520-A is due on March 15 of every year with the IRS. The trust can request a sixth-month extension by submitting Form 7004.
Foreign Grantor Trusts must now apply for an employer identification number (EIN), otherwise your Form 3520-A will be rejected. Call the IRS and get them to issue an EIN and make sure you file on time.
Although for many people, filing Form 3520 and 3520-A is a rare occurrence and is not the same has the annual reporting requirements of having a foreign bank account, it is very important to correctly and timely file these forms, otherwise you will face hefty fines. There is an automatic minimum penalty of $10,000 USD for sending this in late.
When do ISAs become a problem for American expats?
ISAs are very common in the UK, as no further UK tax is due on the income generated in an ISA and they are free of capital gains tax. However, they can be very problematic for US citizens or Green Card Holders.
When ISAs become problematic for US citizens or Green Card Holders depends on the type of ISA. If it is just a cash-based ISA, then there is no issue – you will just have to report the value of the ISA on your FBAR or Form 8938 (Statement of Specified Foreign Financial Assets). Whatever interest the cash-based ISA generates will be reported as interest income on your US tax return.
The more common type of investment ISA, a Stocks and Shares ISA, is more complicated for US citizens or Green Card Holders. The UK does not tax these ISAs, but the US does tax these and taxes them more harshly than a regular investment account.
Investments within a Stocks and Shares ISA can be considered a Passive Foreign Investment Company (PFIC). You’ll have to file IRS Form 8621 for each investment classified as a PFIC, and that form is filed along with your US tax return. With this additional paperwork, you will need to compute the account earnings that are taxable in the US. Income and gains will likely be taxable by IRS.
If I’m an American living in the UK, is it worth having a stocks and shares ISA?
The benefit of having a stocks and shares ISA in the UK is generally outweighed by the costs of US tax compliance and the heavy-handed nature of tax by the IRS.
This is because the US does not want US people to invest their savings outside of the US, so they impose harsh taxes. If you do not do the paperwork properly, you can be subject to the highest US tax rate of 39.6%.
The IRS will tax you on the profits of the PFIC even if you have not sold them. Effectively, you could profit on paper in your ISA that the IRS will want to tax you on before you even have the funds in your hand. Your unrealized gain is being taxed, so you may wonder if there are any exemptions or exclusions to tax on your PFIC. There are ways in which you can have the income taxed at a lower level, but it is dependent on each individual situation and respective income. You can elect a Mark-To-Market or Qualified Electing Fund (QEF) treatment for your PFIC.
The small returns that are typical of many ISAs, it is outweighed by the reporting fees and harsh US taxes.
We recommend that you make sure you only open a cash-based ISA.
What about a Lifetime ISA?
A Lifetime ISA (LISA) can be either cash-based or stock & share-based. If it’s a cash-based ISA, no PFIC filing is required. If it is stock & shared-based, some of your investments could be considered PFICs.
More FAQ’s for U.S. citizens in the United Kingdom
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