Efficient US Pension (401k+IRA) Lump Sum distribution withdrawal in UK

The management of US pensions from the UK seems complex, but it can be made more straightforward with proper information. 401(k) and IRA withdrawals are complex areas where domestic legislation in the US and UK and double taxation agreements cause confusion.

The internet is full of lots of differing opinions and advice; trust professional advice, not a chat forum.

This article is part of a series. This article deals with 401k and IRA Lump Sum Withdrawals, while our forthcoming article on US Pension Regular Withdrawals is covered here.

General withdrawal or distribution rules for 401k or IRA

Generally, distributions from US Pensions 401k and IRAs cannot be made until one of the following occurs.

You are able to take US Pension distributions when:

• Death occurs, you become disabled, or you experience job termination.
• When the plan ends, the employer does not set up or keep a new defined contribution plan.
• If you turn 59½ years old or face a financial hardship situation.

US Pension types of distributions:

• Nonperiodic, such as lump-sum distributions or
• Periodic, such as an annuity or instalment payments.

Before distributing, the plan administrator needs your consent in specific situations. Whenever your account balance goes above $5,000 the plan administrator is required to get your permission before distributing funds. Your 401(k) plan might require your spouse to approve a distribution depending on the offered benefit distribution method. Under your plan terms, rollovers from other plans may not factor into the calculation determining if your account balance surpasses $5,000.

Your 401(k) plan distributions become taxable by default until they undergo the rollover process detailed in the section “Rollovers from your 401(k) plan.” People who received a lump-sum distribution from their 401(k) plan and were born before 1936 may qualify to use unique tax calculation options for their distribution. Details about optional methods to calculate lump-sum distribution taxes exist in Publication 575 Pension and Annuity Income and Form 4972 Instructions PDF Tax on Lump-Sum Distributions.

A lump-sum distribution is the distribution or payment within a single tax year of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans). Additionally, a lump-sum distribution is a distribution that's paid:

Because of the plan participant's death,
After the participant reaches age 59½,
Because the participant, if an employee, separates from service, or
After the participant, if a self-employed individual, becomes totally and permanently disabled.

There is no legislative definition of a Lump Sum but HMRC regards these as being any non-periodic payment of a pension - That is, any non-regular payment that decreases the value of the remaining pension pot after such payment is made.

To provide some guidance on lump sums here are a simple range of scenarios covering lump-sum withdrawals from an IRA or 401(k) for UK individuals reflecting how the UK-US Double Taxation Agreement (DTA), specifically Article 17, applies. Importantly, what does Article 17 say on US Pension distributions.

Understanding Article 17 of the UK-US Double Tax Treaty

Key Treaty Rule – Article 17(2):

“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.”

The Double Taxation Relief (Taxes on Income) (The United States of America) Order 2002

What This Means:

• Lump-sum payments from US pension schemes (IRAs/401(k)s) are taxable only in the US.
• UK should not tax the lump sum under the treaty, but may try to under domestic rules.
• Foreign Tax Credit Relief (FTCR) can mitigate double taxation if the UK insists on taxing.

All the scenarios below require suitable declaring of taking treaty provisions. They cannot just to considered rights and no declaration or reporting is needed. Its important to take advice on your situation as the over simplification in the situations below is purely for guidance and not advice. Contact us to consider if we can help you.

Scenario 1: UK Resident Withdraws a Lump Sum from an IRA

• Details: A UK resident takes a $100,000 lump sum from a traditional IRA.
• US Tax Treatment:
  • Fully taxable in the US as ordinary income.
  • No early withdrawal penalty if over age 59½.
• UK Tax Treatment:
  • Under Article 17(2), the UK should not tax the lump sum.
  • However, under UK domestic law, HMRC may attempt to tax it as foreign pension income.
  • Need to declare on UK Self Assessment in correct manner to take advantage of treaty provisions that override domestic taxation.
• Outcome:
  • The lump sum is taxed only in the US under the treaty where it is declared appropriately in the UK with suitable wording.

Scenario 2: UK Resident Takes a Lump Sum from a 401(k)

• Details: A US UK dual resident withdraws a $75,000 lump sum from a former employer’s 401(k).
• US Tax Treatment:
  • Fully taxable in the US at ordinary income tax rates.
  • Client agrees with 401k provider to elect to withholding taxes equivalent to the US margin tax rate.
• UK Tax Treatment:
  • Per Article 17(2), UK should not tax the lump sum.
  • However, under UK domestic law, HMRC may attempt to tax it as foreign pension income.
  • Need to declare on UK Self Assessment in correct manner to take advantage of treaty provisions that override domestic taxation.
• Outcome:
  • The lump sum is taxed only in the US under the treaty where it is declared appropriately in the UK with suitable wording.

Scenario 3: Roth IRA Lump Sum (UK Perspective)

• Details: A UK resident withdraws $40,000 from a Roth IRA.
• US Tax Treatment:
  • Tax-free in the US if qualified (e.g., over 59½ and account held for 5+ years).
• UK Tax Treatment:
  • The UK recognises Roth IRAs as tax-free.
  • Declare the interest earned inside the IRA as this is taxable as foreign earned interest.
  • No US tax paid, so no foreign tax credit available.
• Outcome:
  • Tax-free in the US and UK.

Scenario 4: Early Withdrawal from an IRA (Before Age 59½)

• Details: A UK resident withdraws $30,000 from an IRA before age 59½.
• US Tax Treatment:
  • Taxed as ordinary income in the US.
  • Withholding tax applied by the IRA provider at 30%
  • 10% early withdrawal penalty applies.
• UK Tax Treatment:
  • Per Article 17(2), the lump sum is taxable only in the US.
  • No UK tax should apply under the treaty.
• Outcome:
  • If US withholding tax is applied, file IRS Form 1040NR to claim a refund. Currently taking a year to be repaid from the IRS.
  • The lump sum is taxed only in the US under the treaty where it is declared appropriately in the UK with suitable wording.

Scenario 5: UK Resident Withdraws a US Lump Sum After Moving Back to the US

• Details: A UK resident moves back to the US and then withdraws $50,000 from a 401(k).
• US Tax Treatment:
  • Now a US resident, so fully taxable in the US.
• UK Tax Treatment:
  • Since no longer UK resident, no UK tax applies.
• Outcome:
  • Tax is only due in the US.
  • No need to claim treaty benefits.

Scenario 6: UK Resident Withdraws a Lump Sum from a US Pension While Also Taking a UK Pension Lump Sum

• Details: A UK resident withdraws:
  • £100,000 from a UK pension, with 25% (£25,000) tax-free.
  • $80,000 from a US 401(k).
• US Tax Treatment:
  • The 401(k) lump sum is fully taxable in the US.
• UK Tax Treatment:
  • The UK pension lump sum has a 25% tax-free allowance.
  • Under Article 17(2), the US lump sum should not be taxed in the UK.
  • Under Article 17(2), the UK lump sum should not be taxed in the US.
• Outcome:
  • The UK lump sum is taxed only on 75% of the amount in the UK.
  • The UK lump sum is not taxed under the treaty where it is declared appropriately to the IRS with suitable wording.
  • The US lump sum is taxed only in the USA under the treaty where it is declared appropriately to HMRC with suitable wording.

Why do I pay US taxes on 401k distribution if I live in the UK and not a US taxpayer?

The US taxes all withdrawals from US pension plans (e.g., 401(k), IRA) as they consider it income sourced in the US. For non-US persons, the default tax withholding rate is 30% on distributions. If both countries tax the withdrawal, you can claim a Foreign Tax Credit (FTC) in the UK for US tax paid.

Withholding tax on 401k or IRA withdrawal(s)

Non-US persons must comply with the IRS demand to withhold 30% of distributions as federal withholding. You cannot waive this withholding. Your present country of residence might have a varied withholding rate in its tax treaty with the United States. Here you will find a list of the current treaty withholding rates.

Non-US persons seeking details on tax withholding can consult Pub. 515 which covers Withholding of Tax on Nonresident Aliens and Foreign Entities as well as Pub. 519 that serves as the U.S. Tax Guide for Aliens.

Getting information on Lump Sum taxation between the USA and UK

Advice from forums and AI has delivered lots of mess where we have needed to tidy up and correctly advise clients. Take advice and don’t fall foul of penalties.

HMRC Community Forum confusing people

The HMRC Community Forums was created to assist users with tax and benefits questions. It allows users to ask questions and find answers. Users can search for existing discussions or post new questions to seek guidance. This forum has had many questions on 401k /IRA withdrawals and taxation. Often, confusion is created by people reading the various posts. According to a Freedom of Information Request, there are 11 staff working as moderators or “HMRC Admin” as they appear in the Forum. It’s quite a task for these eleven people to have the resource books and expertise to answer all questions on tax, which is why we often see clients confused and engage us to provide professional advice.

US pension withdrawal reporting to HMRC

Generally speaking, whether you owe taxes on the 401k or IRA distribution or not, you should, at minimum, notify HMRC of a withdrawal through your self-assessment. Overseas pension are usually in scope for UK tax under UK domestic law, but by notifying them you state you claim relief under a double taxation agreement. You should make a claim for relief under the agreement by notifying HMRC. Its important to report it in the right manner. That’s why we offer the US Pension Lump Sum Withdrawal service.

International pensions can be complex, especially when understanding and interpreting double tax agreements. The information here is simply a beginner’s guide. You can seek independent advice to be clear on your situation.

Early access to 401k IRA before age 59.5

There are IRS rules and acts of law that allow have increasing access to tax-advantaged accounts and preventing older Americans from outliving their assets.

Rule of 55 for early 401k withdrawals

The rule of 55 is where you turn 55 years old (or older) during the calendar year you lose or leave your job, and the IRS allows you to take distributions from your 401(k) without paying the early withdrawal penalty (usually 10% early withdrawal fee). The rule of 55 does not apply to IRAs. The rule of 55 allows you to access your US pension before turning the usual 59.5 years old. You still need to pay income taxes on the withdrawal, even if penalty-free. There are some special requirements for this early 401k withdrawal to be aware of:

• You can only get penalty-free withdrawals from the 401k you contributed to when of the employer before losing or leaving your job. Other 401ks can only be accessed at age 59.5 years old.
• You have to be age 55 in the calendar year lose or leave employment. Age 54 and x number days doesn’t work.
• You can only access the money in the employer’s 401k plan. Rolling over to an IRA will nullify your penalty-free withdrawals.
• If you get another job after using the rule of 55, you can be eligible for penalty-free withdrawals from the 401k you were contributing to at the employer you were working with before leaving your job. You can get a new pension in the new job but only claim penalty-free withdrawals from the 401k scheme you took benefits.

Setting Every Community Up for Retirement Enhancement (SECURE) Act withdrawals

Qualified Birth or Adoption Distribution from US Pension

Parents can take early withdrawals from a 401k or IRA of up to USD5,000 from their US retirement accounts without penalty within a year of a child’s birth or adoption. The USD5,000 limit applies to the individual — not a family — so a spouse may separately receive up to USD5,000. QBOADs are not hardship distributions (which are covered below). They are an entirely new type of distribution subject to their own rules. An eligible plan is not required to permit QBOADs. If it does, the plan must be amended by the last day of the 2022 plan year.

Small penalty-free withdrawals for exceptional situations

Under the SECURE 2.0 Act, effective from 1 January 2024, new regulations permit penalty-free withdrawals from qualified retirement plans during emergency situations or hardships. Retirement savers can take annual emergency withdrawals of $1,000 without facing the 10% tax penalty but will need to pay ordinary income tax on these amounts. A person cannot make further penalty-free withdrawals for personal emergencies during that period unless they repay the withdrawn amount within three years. Individuals need to provide written self-certification to their employer stating that the withdrawal meets emergency requirements such as medical costs or car repairs and foreclosure prevention needs or accident costs and funeral expenses. 

Victims of domestic abuse now have the option to withdraw up to $10,000 or 50% of their vested account balance without penalty depending on which is the lesser amount according to the updated rules. The money withdrawn from these accounts faces ordinary income tax treatment, needs to be completed within a year from when the incident occurred, and allows for self-certification. Victims who repay an amount within three years can obtain a tax refund on that specific repayment. Physical, psychological, sexual, emotional, or economic abuse constitutes domestic abuse according to IRS standards, which also includes controlling, isolating, humiliating or intimidating actions towards victim’s children and family members that live in the household.

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