US tax on my UK lump sum pension withdrawal
Published on July 31, 2023
Updated on March 28, 2025
Reviewed by
Table of Contents
Can the IRS tax my 25% UK lump sum pension withdrawal?
Unfortunately, the IRS doesn’t make things easy. There is no direct answer from the IRS about the taxation of the 25% lump sum pension in the US-UK tax treaty. We have to dig deep into the US tax code and tax treaty to find the answer. Conservatively, major tax firms that specialize in international US tax will treat the lump-sum pension withdrawal as taxable.
There are arguments supporting the position that the IRS will exempt the 25% lump sum payment as the UK does. This is one of the common misunderstandings about the taxation of UK lump sum withdrawals in the US.
What is a lump-sum withdrawal?
Generally, it is withdrawing your funds or contribution all at once, the full 100%. This definition also applies to the US tax code. So, if you take the whole amount of your pension, that’s a lump sum.
However, in this context, the lump-sum pension withdrawal in the UK is only a 25% portion of the whole pension scheme amount. So, this is where taxation gets tricky.
What does the tax treaty say?
The Tax Treaty Article 17(2) says:
“A lump-sum payment derived from a pension scheme established in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the first-mentioned State.”
In other words, a lump-sum payment withdrawn from a pension set up in the UK and owned by a UK resident will only be taxed in the UK. However, the IRS will argue that the 25% you withdrew from your pension was NOT a lump sum, and they will seek to tax you on the amount accordingly.
What is the 25% lump sum withdrawal in the UK?
The 25% lump sum withdrawal in the UK refers to a tax-free amount that UK taxpayers can take from their private pension if they qualify.
Normally, a private pension is taxed as income when withdrawn. Essentially, the whole pension is not tax-exempt, but the UK allows you to take a tax-free lump-sum payment of it. So, some could argue that this qualifies as “lump-sum” on Article 17(2).
Additionally, the US-UK tax treaty does not clearly define the term “lump sum.” Since a lump sum can also mean partial payments in other cultures, there is no clear instruction that partial payments do not qualify.
With this in consideration, the US can still tax withdrawals from UK pensions, including the implications of taking a lump sum with their Saving Clause.
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What is the Saving Clause?
It is a clause that overrides the tax treaty by preserving or “saving” the US government’s right to tax its citizens as if no tax treaty existed.
So, even if we can successfully argue that the 25% UK lump-sum payment qualifies as a lump-sum payment under Article 17(2) if the IRS deems the payment is taxable, the saving clause will trump that rule, and the IRS can still tax you.
Are there exceptions to the Saving Clause?
Yes, Article 1(5) of the Treaty provides several exceptions to the saving clause, but there is no exception for Article 17(2).
So, the provisions of the US-UK tax treaty can be overruled, which can affect the taxation of UK pensions for US citizens.
Is there a way to avoid this?
Other firms may believe that there’s a possibility of avoiding exposing the lump-sum pension withdrawal to US tax based on their reading and understanding of the applicable laws.
However, these approaches could be considered less conservative. It’s important to remember that the taxpayer is ultimately responsible for the accuracy of their tax return, and the IRS heavily penalizes ‘frivolous’ filing positions.
It is one of the compliance requirements for US citizens with UK pensions, including filing tax returns and forms.
Where does that leave me?
- You could pay the tax.
- You could file a US tax return with a Treaty Position on Form 8833.
Form 8833 allows you to present a Treaty Position. You could argue that the saving clause applies only to a 100% lump-sum payment or the other reasons stated above.
If you’re going to take this path, we highly recommend getting professional advice from an international tax attorney or an international tax firm with experience and success filing an 8833 Treaty Position.
What if my 8833 Treaty Position is not accepted?
It could lead to fines, interest, and even an audit. But, more realistically, you would have to pay the tax and interest since the payment was due, along with penalties depending on the pension amount declared exempt.
Is the 8833 route worth trying?
It’s ultimately a matter of interpretation based on your circumstances and risk appetite. Different firms handle UK pension withdrawals in various ways. Additionally, you need to consider the different types of UK pensions and their characteristics.
With all this in mind, the ultimate factors are your personal interests and the nature of the UK pension scheme applied. Most importantly, consult with an international tax expert for personalized advice. This is a very complex issue, and there is a potential risk of handling these matters without professional guidance.
What are other things to consider?
Depending on your contributions and type of pension:
- The IRS may classify some UK pensions as foreign trusts, requiring additional filing requirements for US Foreign Trust Returns for UK pensions.
- Prepare the necessary IRS forms required for reporting UK pensions on US tax returns, such as FinCEN Form 114, Form 1116, Form 3520, and 3520-A.
What’s Expat Tax Online’s view on this matter?
All things considered, the 25% lump-sum pension withdrawal from UK pensions is taxable by the IRS under the US tax code. The key question is how the tax treaty can be overridden and whether the pension withdrawal would have a tax impact after considering the foreign tax credit situation.
Does that mean I can’t work with Expat Tax Online if I want to take a Treaty Position?
Our role is to fully consider and advise you of various filing positions that have a legal basis. You’re the client, and our goal is always to minimize your tax obligations in a legal manner. It may well be that a Treaty Position is viable, but, like everything in tax, it depends on your individual circumstances.
What’s the safest way to report my 25% tax free withdrawal to the IRS?
Declare the income as taxable and use your Foreign Tax Credit carryforwards from your previous ten years of tax returns to offset the tax due. This often reduces the tax due to zero or a significantly smaller amount.
This seems like an easy option, so why doesn’t everyone just do this? If you haven’t been filing every year using the optimum filing position, it would mean filing your last 10 years of tax returns to claim the Foreign Tax Credit.
If you have been filing, but filing Form 2555 (Foreign Earned Income Exclusion) and not claiming tax paid to HMRC, then you’ll likely have to file amended tax returns for the past 10 years to generate the Foreign Tax Credit. Ultimately, it comes down to cost, but it’s often far less than paying the tax on your pension withdrawal.
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