By Anthony Diosdi
In an increasingly global economy, workers are experiencing unprecedented mobility. As such, foreigners living in America, even for a limited time, often participate in a pension or retirement plan in the United States; participation might even be mandatory. In most cases, pretax money is contributed into retirement accounts where it accumulates tax-free until retirement. U.S. retirement such as 403(b) plans, 401(k) plans, and Individual Retirement Accounts (“IRAs”) are commonly encountered by foreigners who are employed in the United States. In the alternative, Americans who are employed abroad often contribute to foreign retirement plans. Whether contributions, earnings, and distributions are includible in a foreign worker’s U.S. taxable income depends on how the worker is classified for U.S. tax purposes and whether a tax treaty exempts an event that is otherwise taxable. This article will discuss how the United States- United Kingdom Income Tax Treaty (hereinafter U.S.- U.K. Income Tax Treaty) can potentially be utilized to minimize the income tax consequences on U.S. and U.K based retirement plans.
Taxation of U.S. Based Retirement Distributions
We will begin our discussion with a discussion of U.S. based retirement accounts and how foreigner participants are taxed under U.S. law. The most common U.S. retirement plans, for U.S. tax purposes are 401(k) plans, 403(b) plans, and individual retirement accounts. The applicable classification depends on the employer, contributions, and other factors. Below, these retirement accounts are discussed in more detail.
401(k) Plan
A 401(k) plan is an employer-sponsored defined-contribution account defined in Section 401(k) of the Internal Revenue Code. (Unless otherwise specified, all sections are to the Internal Revenue Code of 1986 (“IRC” or “Section”) or the regulations thereunder, both as amended through the date of this article. All references to U.S. taxes herein are to federal taxes, unless otherwise specified).
Employee funding comes directly from their paycheck and contributions may be matched by the employer. Income taxes on pre-contributions and investment earnings are tax deferred. For pre-tax contributions, the employee does not pay federal income tax on the amount of current income he or she transfers to a 401(k) account, but does still pay the 7.65 percent payroll taxes (social security and medicare). Employees of a business with a 401(k) are allowed to contribute up to $19,500 for 2021. For U.S. tax purposes, the participant pays income taxes on the plan distribution when funds are withdrawn from the plan. If an individual needs to access 401(k) funds before the year the participant turns 59 1/2, the participant will be assessed a 10 percent penalty on any withdrawals made in addition to income taxes owed on the withdrawal. In some cases, participants can withdraw funds from a 401(k) plan at age 55 without incurring the 10 percent penalty.
403(b) Plans
403(b) plans resemble 401(k) plans but they serve employees of public schools and tax-exempt organizations rather than private sector workers. Contributions made to a 403(b) plan are not taxed until money is withdrawn from the plan. For 2021, the most an employee can contribute to a 403(b) account is $19,500 in 2021. For U.S. tax purposes, the participant pays income taxes on the plan distribution when funds are withdrawn from the plan. If an individual needs to access 403(b) funds before the year the participant turns 59 1/2, the participant will be assessed a 10 percent penalty on any withdrawals made in addition to income taxes owed on the withdrawal. In some cases, participants can withdraw funds from a 401(k) plan at age 55 without incurring the 10 percent penalty.
Individual Retirement Accounts
An individual retirement account or (“IRA”) is a form of individual retirement plan, provided by many financial institutions, that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with an individual’s earned income for the individual’s eventual retirement. For the 2021 tax year, the total contributions an individual may make to a traditional IRA is $6,000 ($7,000 if the individual is age 50 or older). For U.S. tax purposes, the participant pays income taxes on the plan distribution when funds are withdrawn from the plan. If an individual needs to access IRA funds before the year the participant turns 59 1/2, the participant will be assessed a 10 percent penalty on any withdrawals made in addition to income taxes owed on the withdrawal.
Taxation of Retirement Contributions and the Taxation of the Accumulated Earnings in a U.S. Based Retirement Plan
The U.S. tax consequences of distributions from a U.S. based retirement account depends on whether a non-U.S. citizen is classified as nonresident or resident for U.S. income tax consequences. We will begin first with discussing the income tax consequences to non-U.S. citizens who are not “U.S. residents” for income tax purposes. Foreign persons that are not “U.S. residents” are only taxed on their U.S. source income. For U.S. source income, foreign persons are subject to two different U.S. taxing regimes. One regime applies to income that is connected with the conduct of a trade or business in the United States. The other regime applies to certain types of nonbusiness income from U.S. sources. If a foreign person conducts a trade or business in the United States, the net income effectively connected with the U.S. business activity will be taxed at the usual tax rates. At present, the top nominal marginal rate paid by individual taxpayers is 37 percent. The determination of whether a foreign person is engaged in the conduct of a trade or business in the United States generally. However, appropriate deductions and credits will apply in the determination of U.S. tax liability.
Most of the forms of U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of the income received. Section 871(a) of the Internal Revenue Code imposes the 30-percent tax on “interest * * * dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income.” The collection of such taxes is affected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person to withhold the tax and pay it over to the Internal Revenue Service (“IRS”). Distributions from U.S.- based retirement accounts are subject to the 30 percent withholding rules discussed above. Thus, when a non-U.S. resident for tax purposes receives a distribution from a U.S.-based retirement account, unless treaty applies, he or she will be subject to a 30 percent withholding. A nonresident may also be subject to a 10 percent penalty for early withdrawal from the U.S.-based retirement account.
The tax rules are different for non-U.S. citizens that are taxed as “U.S. residents.” U.S. residents are subject to federal income tax on their worldwide income regardless of the country from which the income derives, the country in which payment is made or the currency in which the income is received. On the other hand, all U.S. source income received by U.S. residents is taxed at U.S. prgressive ordinary income or capital gain rates. When a U.S. resident withdraws funds from a U.S.-based retirement account, he or she is taxed at progressive ordinary rates. In order to discourage the early withdrawal of funds, Section 72(t) of Internal Revenue Code imposes a 10 percent additional income tax on distributions which fails to satisfy certain criteria- such as early withdrawal. U.S. residents are also subject to a 20 percent withholding tax on distributions from U.S.-based retirement accounts. However, a U.S. resident can receive a refund from the IRS any overpayment of tax.
Applying the U.S- U.K. Tax Treaty to U.S. Retirement Account Distributions
Let’s assume that Tom is a U.K. citizen that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to the U.K. and would like to withdraw money from his U.S. based IRA. However, Tom is concerned about the U.S. federal 30 percent withholding tax and the 10 percent early withdrawal penalty.
Since Tom is a citizen of the United Kingdom, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the U.S.- U.K Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty.
Under Article 17 of the U.S- U.K. Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. Under the provisions of the U.S.- United Kingdom Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom has returned to the United Kingdom and is presumably taxed in that country, Tom is a resident of the United Kingdom. It should be noted that Article 17 of the U.S.- U.K. Income Tax Treaty should be carefully read with the “savings clause” of Article 1 of the treaty. Under Article 1 of the U.S.- U.K. Income Tax Treaty, the United States and the United Kingdom each reserve the right to tax their own citizens “as if this Convention had not come into effect.” Consequently, if Tom were a U.S. citizen, he could not take a treaty position to reduce U.S. tax liabilities associated with his IRA.
We next must define the term “pension” under the treaty. The U.S.- U.K. Income Tax Treaty and its Technical Explanations define “pension distributions” as follows:
“it is understood for this purpose that U.S. pension schemes eligible for the benefits of paragraph 2 include qualified plans under Section 401(a), individual retirement plans (including individual retirement plans that are part of a simplified employee pension plan that satisfies Section 408(k)), individual retirement accounts, individual retirement annuities, Section 408(p) accounts and Roth IRAs under Section 408(A), Section 403(a) qualified annuity plans, and Section 403(b) plans.”
Since the Technical Explanations to the treaty specifically includes individual retirement accounts or IRAs in the definition of a “pension and other similar renunciations,” Tom can potentially utilize the U.S.- U.K. Income Tax Treaty to avoid U.S. tax consequences and early withdrawal penalties from the distribution of his IRA.
U.S. Taxation of U.K. Retirement Plans
Foreign pension plans, including U.K. employer-sponsored pension plans are similar to U.S. based retirement accounts in that pre tax wages are contributed into retirement accounts. The pre tax money accumulates in the plan tax-free until the participant retires. Unless the foreign pension plan is a “qualified” plan as defined by Internal Revenue Code Section 401, under U.S. law, the participant’s contributions to the plan are not deductible for U.S. tax purposes, and any employer contributions to the participant are subject to U.S. tax. Consequently, many Americans working abroad are immediately taxed on contributions and employer matching contributions to a foreign retirement plan. However, the U.S.- U.K. Income Tax Treaty provides an exception to these general rules. For example, let’s assume that Tom is a U.S. citizen living and working in the United Kingdom. Let’s also assume that Tom contributes to a U.K. self-invested personal pension (“SIPP”). Not only would Tom receive a tax deduction in the U.K. in connection with his contributions to the plan, under Article 18 of the U.S.- U.K. Tax Treaty, Tom could receive a tax deduction in the U.S. associated with contributions to the plan. This U.S. deduction would be available to Tom as long as he resides in the United Kingdom. Alternatively, Tom could contribute a portion of his U.K salary to a U.S. based 401(k) plan, provided that Tom had already enrolled in the plan prior to moving to the U.K.
Can the U.K. Pension 25 Percent Lump-Sum Tax Offer U.S. Tax Savings Opportunity?
The United Kingdom has an usual method of taxing pensions. The United Kingdom government will not tax 25 percent lump-sum pension payments as a matter of U.K tax law. The question many beneficiaries of U.K. pensions have is does the U.S. recognize this same tax benefit by virtue of the U.S.- U.K. Tax Treaty? Article 17 of the U.S.- U.K. Income Tax Treaty also known as the “reciprocal pension exemption” seems to provide authority for a U.S. person with a beneficial interest in a U.K pension to avoid U.S. taxation on 25 percent of the pension commencement lump sum or (“PCLS”). However, Article 1 or “Savings Clause” of the U.S.- U.K. Tax Treaty may override Article 17 of the treaty and result in the U.S. taxation of the entire U.K. pension plan. This area is somewhat unsettled. Thus, a U.S. beneficiary of a U.K. pension plan should consult with a qualified international tax attorney.
Reporting Requirements
Anyone that claims the benefits of the U.S.- U.K. Income Tax Treaty for U.S. tax purposes must disclose the position on their U.S. tax return. See IRC Section 6114. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
U.S. beneficiaries of U.K pension plans will also likely need to disclose the pension plan on a FinCen 114 and IRS Form 8938.
Conclusion
Often the terms of a U.S. tax treaty modify the tax results that one would otherwise obtain under the Internal Revenue Code. Correctly taking a treaty position can result in substantial tax savings. On the other hand, taking an incorrect treaty position can result in the assessment of significant penalties and interest by the IRS. If you are considering taking a treaty position regarding a U.S. or U.K. based retirement account, you should consult with an experienced international tax attorney to assist you. We have advised a substantial number of clients regarding taking income tax treaty positions in connection with U.S. based and foreign retirement plans..
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.