US tax on my UK lump sum pension withdrawal
Can the IRS tax my 25% UK lump sum pension withdrawal?
There isn’t an easy answer to this question and, like many international tax issues, it’s complicated.
There are arguments that support the IRS taxing the 25% lump-sum pension withdrawal and there are arguments supporting the position that the IRS will exempt it, like the UK does.
Unfortunately, the IRS doesn’t make things easy and, like many things in life, there’s always alternative viewpoints and interpretations. It would be nice to say that clear guidance is provided as to how to treat many aspects of foreign income and investments but often there’s no guidance at all, clear or otherwise. Instead, it’s left to tax professionals to study the tax code – along with various tax treaties and totalization agreements – and decide how they should report and disclose the various items.
Naturally, in the absence of 100% clear guidance, it’s ‘easiest’ to treat the lump-sum pension withdrawal as taxable. After all, it’s highly unlikely to upset the IRS or cause any problems for them or their client beyond the cost of the tax bill; which is possibly mitigated by carry over foreign tax credits anyway.
Other firms may believe, based on their reading and understanding of the applicable laws, that there’s a possibility to avoid exposing the lump-sum pension withdrawal to US tax. These approaches could be considered less conservative, but it’s important to remember that the taxpayer is always reasonable for the accuracy of their tax return and the IRS heavily penalizes ‘frivolous’ filing positions. The crux of the issue is the term ‘lump-sum’ as the definition impacts which part of the tax treaty is used.
You may find that good international law firms sit somewhere between these two positions, advocating the possibility of both approaches depending on various aspects of the pension withdrawal. There may be pros and cons to both options but, as with many things in life, there is usually a balanced middle ground, after taking all factors and circumstances into account.
Lump Sum v Lump Sum
Not quite.
The US tax code describes a “lump sum” as 100% which means withdrawing everything in your pension in one go. If you take the whole amount out of your pension, that’s a lump sum. However, in the UK, 25% is also described as a “lump sum”.
For further context, the OECD[1] has clarified that a lump-sum distribution is anything other than “periodic payments”.
There’s IRS rulings on this matter but they cannot be definitively used as precedent as they only apply to the individual named in the ruling.
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”
Let’s try that again in simple terms…
A lump-sum payment withdrawn from a pension that was set up in the UK and owned by a resident of the UK^ will only be taxed in the UK.
That’s great if we can stop reading the tax treaty right now.
^Also a US tax resident. All US citizens are US tax residents, even if they live in another country.
Remember: the US meaning of “lump sum” is 100% of the pension.
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.
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[1] The Organisation for Economic Co-operation and Development is an intergovernmental organization with 38 member countries, founded in 1961 to stimulate economic progress and world trade. Both the US and the UK are members. If both the US and the UK were members of the OECD when a treaty was drafted, United States courts must refer to OECD commentary, which is refreshed every 48 months, to examine the meaning of terms used in the income tax treaty. The OECD says anything other than a 100% withdrawal is a “periodic payment”.
The IRS has an ace up its sleeve.
It’s called the saving clause, and in simple terms, it is a clause which overrides the tax treaty by preserving or “saving” the US government’s right to tax its citizens as if no tax treaty existed.
Article 17(2) helps us to interpret the meaning of “lump sum” and if we can successfully argue that our UK 25% lump-sum withdrawal applies, the IRS will apply the saving clause.
So, even if you can show that the 25% tax-free lump-sum payment qualified as a lump-sum payment under Article 17(2), the saving clause will trump that rule and the IRS can still tax you.
If the IRS looks closely at your tax return and your tax treaty disclosure statement, the likely outcome is that it will expect you to pay the tax. Don’t underestimate the “if” here.
In 2008 the IRS provided clarity on these arguments.
“Article 1(5) of the Treaty provides a number of exceptions to the saving clause, but there is no exception for Article 17(2).
The saving clause overrides Article 17(2) and allows the United States to tax a lump-sum payment received by a U.S. resident from a United Kingdom pension plan.”
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. For example, you could argue that the saving clause applies only to a 100% lump-sum payment.
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 amount of the pension that was declared exempt.
Is the 8833 route worth trying?
It’s ultimately a matter of interpretation based on individual circumstances and risk.
Going back to the beginning of the article, I mentioned that different firms handle UK pension withdrawals in various ways.
What’s the view of Expat Tax Online on this matter?
All things considered, the 25% lump-sum pension withdrawals from UK pensions will be taxed by the IRS under domestic IRS law. The key question is around tax treaty override 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 my next step?
Don’t make any hasty decisions.
If you haven’t already, get in touch for an obligation-free chat, and we’ll do everything we can to help. Contact us now.
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