Is the UK pension lump sum taxable in the US?

How does the UK treat a pension lump sum?

The UK lets most members of a workplace or personal pension take part of the fund as a lump sum free of income tax. It is usually up to a quarter of the amount built up, subject to an overall cap. Anything taken beyond that is taxed as income, whatever form it takes.

The GOV.UK guidance on what is tax-free when you take a pension (opens the official GOV.UK page in a new tab) sets out the fraction and the cap, and notes that some people hold a protected allowance that raises their limit. The tax-free amount does not use up the personal allowance. On the rest, the provider deducts tax before paying. Pension rules call the tax-free payment a pension commencement lump sum.

For US purposes the two parts need separate answers. The taxable remainder, whether drawn as further withdrawals, drawdown income or an annuity, is the easier one: the UK taxes it, the US taxes its citizen on it, and the US gives credit for the UK tax on Form 1116. The tax-free part is the difficulty, because the UK charges nothing on it. The State Pension (opens the official GOV.UK page in a new tab) is a different matter again. It is a social security payment, dealt with by a separate paragraph of the treaty, and is outside this post.

What do Articles 17(1) and 17(2) of the US-UK treaty say?

Article 17(1) gives pensions to the country where the recipient lives, and adds that an amount the scheme's country would exempt for its own resident is exempt in the residence country too. Article 17(2) then takes lump sums out of that rule and gives them to the country where the scheme is established.

The wording, in the convention published with the IRS treaty documents (opens the official IRS page in a new tab) and on GOV.UK under USA: tax treaties (opens the official GOV.UK page in a new tab), is short. The Treasury's technical explanation illustrates Article 17(1)(b) with a US Roth account: a distribution to a UK resident is exempt in the UK to the extent it would be exempt in the US if paid to a US resident.

The technical explanation also records why paragraph 2 exists. Under the earlier convention a lump sum was taxed only in the country of residence, and the UK does not tax pension lump sums. A person expecting a lump sum from a US plan could become UK resident for the year of payment and pay tax in neither country. Paragraph 2 closes that gap by sending the lump sum back to the country of the scheme. Article 17 does not define what counts as a lump-sum payment.

• Article 17(1)(a). Pensions and similar remuneration are taxable only in the recipient's country of residence
• Article 17(1)(b). An amount paid from a scheme in the other country that would be exempt there for a resident is exempt in the residence country as well
• Article 17(2). A lump-sum payment from a scheme in one country, beneficially owned by a resident of the other, is taxable only in the scheme's country

Which parts of Article 17 survive the saving clause?

Only some. Article 1(4), the saving clause, lets the United States tax its citizens as if the treaty had not come into effect, subject to the exceptions in Article 1(5). Of Article 17, the list in Article 1(5) names sub-paragraph (b) of paragraph 1, paragraph 3 and paragraph 5. Paragraph 2, on lump sums, is not there.

That list is in Article 1(5)(a), as replaced by the 2002 protocol, and its benefits are available to everyone, a country's own citizens included. Our post on the saving clause goes through it in full. The same list protects Article 18(1), which is why growth inside a UK pension is generally protected for a US citizen. Relief for contributions is a separate and narrower benefit under Article 18(5), limited by conditions.

This is where a US citizen differs from other UK residents. A UK resident who is neither a US citizen nor a green card holder is outside the saving clause, so the United States has no claim on a lump sum from that person's UK scheme, and Article 17(2) would give the US the sole right to tax a lump sum from a US plan. A US citizen cannot rely on Article 17(2) against the United States at all. Our summary of the US-UK tax treaty covers the rest.

• Protected for a US citizen: the matching exemption in Article 17(1)(b)
• Protected for a US citizen: social security under Article 17(3), and alimony and child support under Article 17(5)
• Not protected: the residence rule for pensions in Article 17(1)(a)
• Not protected: the lump sum rule in Article 17(2) and the annuity rule in Article 17(4)

Why is the US treatment of the tax-free lump sum contested?

Because the technical explanation supports two readings. It says a US citizen who receives a distribution from a UK pension scheme is taxable only on the portion that is taxable in the UK. It also says a US citizen resident in the UK remains subject to US tax on a lump-sum distribution from a pension scheme.

One reading starts from Article 17(1)(b). That sub-paragraph is protected from the saving clause, the tax-free amount would be exempt in the UK in the hands of a UK resident, and so the United States must exempt it for its citizen. On this view the statement about lump sums concerns payments that the UK itself would tax, or the commutation of a whole fund, and not the tax-free portion taken when benefits begin.

The other reading starts from Article 17(2). The technical explanation says that, although a pension would ordinarily include a lump sum, paragraph 2 provides specific rules for lump sums, so they are not subject to the general rule in paragraph 1. If the tax-free payment is a lump-sum payment in that sense, the matching exemption does not reach it, paragraph 2 is overridden by the saving clause, and US domestic law applies.

IRS publications do not settle it. An information letter and a Chief Counsel memorandum, both issued in 2008, state that the saving clause lets the United States tax a lump sum paid from a UK scheme to a US resident. Neither discusses Article 17(1)(b) or the tax-free amount received by a citizen living in the UK, and neither is a ruling or a precedent. We have found no IRS guidance that names the UK tax-free lump sum.

How does US law tax the lump sum if no exemption applies?

Under domestic law a distribution from a foreign pension is taxable to a US citizen to the extent it exceeds the cost, also called the investment in the contract. IRS guidance on foreign pensions puts the taxable amount as the gross distribution less that cost. The UK label of tax-free has no effect on the calculation.

Cost is set out in Publication 575 (opens the official IRS page in a new tab). In broad terms it is the member's net investment that has already borne US tax. Amounts that went in on a tax-deferred basis are not cost, and the publication counts employer contributions for work abroad only in limited cases. For many Americans with UK workplace pensions that leaves a small cost or none, so most of a lump sum would be taxable. Where earlier US returns did tax contributions, those records support a cost figure.

Credit relief does not solve the problem. The foreign tax credit (opens the official IRS page in a new tab) is given for foreign income tax paid or accrued on income the US also taxes. The UK charges no tax on the tax-free part, so there is no UK tax on it to credit, and the US tax is a real cost unless something else absorbs it.

Something else sometimes does. Unused credits from earlier years carry back one year and forward ten, within the same category of income. Whether a balance can be set against US tax on a pension payment depends on the category and the limitation for the year, and should be modelled before the withdrawal.

How is a treaty position on the lump sum disclosed?

A position that the treaty overrides US tax law and reduces tax is disclosed on Form 8833, attached to the return. The IRS waives the form for some treaty positions on pensions, but with a contested reading the cautious practice is to file it and state the article relied on. A penalty applies to each failure to disclose a reportable position.

The page for Form 8833 (opens the official IRS page in a new tab) describes the disclosure, and our guide to Form 8833 explains how the form is completed. Disclosure shows the IRS what has been claimed and why. It does not make the position correct. If the IRS examined the return and took the other reading, the tax would be due, and interest and penalties could follow. Anyone taking the position should be able to fund that outcome.

Take a US citizen resident in Bristol who retires from a UK employer and takes the tax-free amount from a workplace pension, leaving the rest in drawdown. The UK taxes the drawdown income and nothing else. On her US return she reports the drawdown income and credits the UK tax. For the lump sum she has to choose: report it as taxable less any cost, or claim the Article 17(1)(b) exemption and disclose it. Neither choice is free of risk, and the right one depends on the size of the payment and her carried-forward credits.

We review that choice before the money is taken, through our US-UK pensions service and our treaty relief service. Reporting of the scheme itself is a separate question, covered in our post on whether a UK pension is reportable on the FBAR. For how the treaty, the credit and the other reliefs fit together, return to the guide to avoiding US-UK double taxation.

• The type of scheme, and whether it meets the treaty definition of a pension scheme
• How the payment is described by the provider, and whether further benefits continue
• Contributions already taxed on earlier US returns, with evidence
• Foreign tax credit carryovers by category, and when they expire
• State tax, since some states do not follow the federal treaty position