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As in many countries, the UK government promotes saving for retirement by encouraging people to contribute into a pension which can be used at retirement. As the Baby Boomer generation starts to retire in droves, the availability of Defined Benefit (DB) pension plans is almost non-existent. Nearly all pension schemes available today in the UK are Defined Contributions (DC) plans. Generally, money contributed into a pension is not taxed, and any growth is tax-deferred. Distributions are taxed as income when taken in retirement (except any tax-free cash element). For American taxpayers living in the UK things are not as straightforward, because there are also US tax implications to be considered.
If you are a UK taxpayer, in the tax year 2019-20 the general rule is that you will receive tax relief on the lesser of your pension contributions of up to 100% of your earnings, or the £40,000 annual allowance. The level of relief you can claim depends on the tax bracket you are in (20%, 40% or 45%).&8226; For example, if you earn £40,000 and decide to put £20,000 into your pension pot you will get tax relief on £20,000 (at 20%).
From April 6, 2016 the annual allowance available for additional rate taxpayers (45%) is tapered down from £40,000, and once earnings exceed £210,000 per year the annual allowance reduces to £10,000. Ultimately, individual circumstances dictate how much can be contributed, and as with all rules, they may change in the future.
Many American taxpayers earning a living in the UK pay more UK income taxes than they would otherwise pay in the US, and these surplus taxes (called excess Foreign Tax Credits) are only of value if they can be used to reduce US taxes. Essentially, pension contributions lower the individual’s UK taxable income, and in so doing allow the American taxpayer to reduce their overall tax liability. The most tax-efficient contribution from a US perspective is where the individual’s UK income is reduced to the point whereby the UK and US taxes become equivalent. As there are many factors to consider, for many Americans this may end up being quite a difficult calculation, so it is advisable that you seek advice from your tax advisor.
For an American taxpayer, the correct amount of contribution can effectively use up surplus Foreign Tax Credits, which otherwise would expire or not be utilised in full, and provide ‘tax basis’ in the pension from a US perspective. Tax basis represents value within the plan that is after-tax. This can be immensely valuable when qualified distributions are eventually taken from the plan.
Effective tax planning conducted as early as possible could result in large savings over the life of the pension plan. For overseas Americans who plan on retiring in the US, the possibility of building basis in a pension plan presents an opportunity to make large savings over the life of the pension plan. Effective tax planning as early as possible is key to ensuring you can maximise the potential benefits of being an expat.
However, there are a few things that need to be taken into consideration when reviewing your pensions for tax efficiency. The most important point to note is that for US tax purposes all UK pension plans are considered ‘non-qualified plans.’ What that essentially means is that for a UK pension plan to receive preferential tax treatment under US rules it must meet certain strict conditions set out in the US tax code. Falling foul of these conditions could result in the pension plan being treated as a ‘Foreign Grantor Trust’, resulting in the loss of the ‘Retirement Plan’ tax-efficient wrapper and the contributions and income accrued within the plan being taxed annually, even if no distributions are made. In addition to this, as the pension plan would be considered a Trust under US rules, the 3520 and 3520-A Trust forms (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts) will need to be filed annually. As the pension wrapper does not exist in this case, any investments within the fund that are considered to be Passive Foreign Investment Companies (PFICs) would be subject to punitive tax rates. In certain situations, this treatment can work out to be the desired outcome, but in the majority of cases Americans would benefit from not receiving such treatment when contributing towards a UK pension plan. For many Americans living in the UK, relevant tax treaty elections can be made to avoid the negative treatment of non-qualified foreign pension plans, but in so doing certain tax planning opportunities may be forfeited.
The tax rules relating to pensions are quite complex, and anyone who has attempted to analyse the US/UK tax treaty and apply it to their own circumstance can appreciate how confusing things can become. Pensions can be the most tax efficient way to invest your money while living and working in the UK, and with the relatively high investment limits the time and effort spent reviewing your pension positions is likely to be a worthwhile investment.
Corniche Consulting’s London based US & UK specialist tax team provide comprehensive US and UK tax support for Americans living and working in the UK. If you would like to talk to someone in the team about your tax affairs, please email us at email@example.com.