Tax on UK Pension Withdrawals

A relatively quick one today, on a topic I’ve been trying to nail down for a while. Disclosure up front – as always, I’m not a professional. This topic is particularly complex, and I invite discussion and disagreement; I’ll happily update this post if anybody finds any inaccuracies and call out any alternative viewpoints. Just leave a comment and we can talk 🙂

I’ll also caveat that this is a high-level, conceptual discussion. I’ve summarized about 134 pages of IRS publications in just over 1,300 words – there are many details and caveats that you’d need to research before relying on this.

The focus for today is taxation of withdrawals from your UK pension. I’m mostly considering defined contribution pensions – both workplace and a SIPP – although the same concepts generally apply for defined benefit. We’ll consider all three main withdrawal types: flexi-access drawdown, lump sum (UFPLS), and annuity.

Quick summary: the UK tax situation is clear, the US one not quite so much but still reasonable. Key takeaway is that the method of your withdrawals (periodic vs nonperiodic) has an interesting effect on how the US taxes you, something we might be able to use to our advantage (or at least need to consider in our planning). Also, it looks like it’s usually best to include pension contributions in your taxable income while you’re working.

UK Tax

The UK side is the easy part: 25% of your pension is tax-free, 75% is taxable income. You can take the 25% up front or as part of later withdrawals – for most US citizens, you won’t want that big lump sum that’s UK tax-free but probably US taxable, because you likely won’t have enough Foreign Tax Credits to fully offset the US tax, resulting in you paying real dollars to the IRS.

Today, I’m not going to discuss any further whether the US respects the tax-free status of that 25%. That’s a knotty treaty question, and not one I’m 100% convinced about. If I had to say, I find it more convincing that the US will tax all of the pension, not just 75% of it, but that’s far from a certainty.

US Tax

The US approach to tax on a UK pension depends significantly on whether you take the withdrawals as periodic payments or nonperiodic payments, so we’ll treat them separately.

Periodic Payments

This would obviously include a traditional annuity, but also if you set up a flexi-access drawdown to pay you automatically on a periodic basis – for example, if you want a pre-set monthly income. The IRS just requires that the periodic payments be paid at regular intervals (weekly, monthly, annually, etc.) for a period of time greater than 1 year.

All the details are in IRS Publication 939, and is called the “General Rule” (which is confusing, because the “Simplified Rule” seems to be actually more common for most Americans, since it applies to 401(k)s and the like, but go with it). Grab a strong cup of coffee before you dig into that one, but in a nutshell:

• In general, the portion of each payment that can be attributed to contributions to the pension is tax-free, while the part coming from gains is taxable.
  • This assumes that the contributions were subject to income tax when they were contributed, both employer and employee contributions. If they were excluded, they don’t count as cost (makes sense – you now have to “pay” income tax on withdrawal since you didn’t “pay” when earned).
• Because it’s a periodic series of payments, every payment includes both tax-free and taxable portions, in proportion to the overall ratio of contributions to gains.
• Figuring the cost of the pension is mostly as simple as totaling up all the contributions – there are some subtractions for refunded premiums, unrepaid loans, and so on, but these are probably rare. The most likely would be any contributions that were previously withdrawn as a nonperiodic payment
• Then there’s some calculations to do:
  • For an actual annuity, take a look at Pub 939, because there are specific cases for different types of annuities.
  • For periodic payments other than an annuity, you use an actuarial table to look up how many payments you expect to get. For example, if you’re 65, the IRS expects you to live another 20 years. Then, you divide the cost of the pension by the expected number of payments. For example, if you are 65 and have £120,000 of cost in the pension, you divide £120,000 by 20 to get £6,000 tax-free for each annual payment.
    • This part is a little tough to read in the pub, because it talks so much about annuities and not much about non-annuity periodic payments. If somebody else reads this section and comes to a different conclusion, I’d love to hear it!

Nonperiodic Payments

This would apply to lump sums (UFPLS) as well as nonperiodic flexi-access drawdowns. This is discussed in IRS Publication 575, which mostly covers the “Simplified Rule” that applies to qualified US plans, but also throws in this nonperiodic part.

There’s two sub-options here:

1. If you take the payment before starting periodic payments (most likely), the payment is first allocated to gains in the pension and are fully taxable, until you’ve withdrawn all the gains. Then the payments are allocated to the cost of the pension, and are tax free.
   • Like with periodic payments, the cost of the pension is the sum of all the contributions that were included in taxable income, with some potential adjustments and caveats.
   • In practice, I think this means that all of your “early” nonperiodic payments would be fully US taxable until you’ve withdrawn all the gains, then all your “late” periodic payments would be US tax free.
2. If you take the payment at the same time you start periodic payments or after they start (as in, you’ve got periodic flexi-access drawdown going but then you take a lump sum), the entire payment is taxable, unless the subsequent periodic payments will be reduced because of the nonperiodic payment. In that case, a portion of the payment will be non-taxable, in proportion to the reduction in future payments (there’s a slightly complex calculation involved).

So What?

Two key takeaways for me:

• It is likely to most people’s benefit to include employer and employee pension contributions in your US taxable income while you’re working.
  • Under the US/UK tax treaty, you do have the option to exclude these contributions. Because UK income tax rates are higher than US ones, you’ll build up Foreign Tax Credits more quickly if you have less US taxable income, and potentially could use those FTCs if you start pension withdrawals within the next 10 years. That’s good, because if you don’t include these contributions, you probably won’t have any cost basis in your pension – effectively all of your withdrawals will be US taxable.
    • If nothing big changes from now, that still probably doesn’t matter much – the UK taxes on 75% of a withdrawals are still mostly more than US taxes on 100%, so FTCs wipe out any US tax owed. But that’s a pretty close calculation today, and could easily change over the years with tax updates, exchange rate movements, etc.
  • If you don’t exclude the contributions from your taxable income, you “pay” US tax in the year the contributions are made (probably, you just use FTCs and don’t actually owe anything), and build up the cost basis in your pension. In withdrawal, that means a big chunk of your pension is tax-free, and you only need to worry about US tax on the gains.
• The differing US tax treatment of periodic vs nonperiodic withdrawals might open some interesting opportunities in retirement. For example:
  • If you’ve living off periodic payments from your UK pension in the first few years of “middle retirement” (Phase 2), the fact that only part of the withdrawal is US taxable could give you more space in the low/no tax brackets for Roth conversions
  • Since nonperiodic (lump sum) withdrawals start as taxable and then switch to tax-free once you’ve gone through all your gains, there might be an opportunity to take advantage of that switch, potentially with a substantial US and UK tax-free lump sum. There are definitely drawbacks here too, but something to think about.
  • At the very least, the two different regimes bear including in your planning, even if you wind up with a simple approach.

Any other thoughts? Ideas for how this might help or hinder you? Leave a note in the comments.

There won’t be a post next week, but I’m slowly working on wrapping up my withdrawal planning series – hopefully done by the end of June!

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