One of those questions that UK-trained and focused advisers who look after American expat clients only occasionally say they come up against from time to time – and often end up having to consult an American wealth management specialist in order to know how to respond – concerns the tax obligations these Americans would incur when they go to cash in their American savings products.
Aware that International Investment occasionally puts technical questions such as this to experts to solve in column form, to the benefit of other equally-baffled advisers, one such UK-based adviser passed along to us just such a US product sale query – in this case, involving something called a Roth Individual Retirement Account.
Below is this adviser’s query in full, followed by a detailed explanation from one of the experts at Maseco Private Wealth, the London-based advisory business which specialises in looking after American expats around the world. The expert in question is Andrea Solana, pictured above, who is head of advanced planning at Maseco PW, and who is also herself an American expatriate.
“I work for a UK-based wealth manager, with clients who often come from other countries, and/or who have spouses who do. Thus it is that the wife of one of my British clients is an American, and has what is called a Roth Individual Retirement Account (Roth IRA) – a tax-advantaged US savings scheme. She has been living in the UK for more than 15 years, is married to a UK citizen, and is the mother of children who were born here. She has dual UK – US citizenship.
“Recently she told me that she wants to take all the money out of her Roth IRA, which is about US$15,000, but she is concerned that she might be expected to pay tax on the amount in the US, or the UK, or both.This is a new one for me. What should I tell her?
“(I should mention that she has no plans ever to return to the US, although I would not want to encourage her to do something which might make it awkward or expensive if she were to unexpectedly have to go there one day, and face potential consequences resulting from not paying tax on this encashment.)
“And, while I’m at it, might I also ask what the situation would be if it weren’t a Roth IRA, but a regular IRA? What is a ‘Roth IRA’ anyway?”
Andrea Solana’s response:
It is fairly common for any individual who has lived and worked in the US for a period of time to have at least one US-based retirement account. These can take form in a number of different types of accounts. The most common ones you see are 401k plans (the US equivalent of an employer based scheme), traditional IRAs (the US equivalent of a SIPP or other personal pension plan), and Roth IRAs (the US retirement equivalent of an ISA).
These plans can be an individual’s own plan, or one that was inherited from another individual at their death.
Typically 401k plans and traditional IRAs are made up of pre-tax contributions and earnings that are tax-deferred until distribution in retirement. The conventional wisdom here is that an employed individual will be in a higher tax bracket during their working years, and thus contributions to these types of plans will allow them to receive tax relief at the time of contribution, and defer that tax until retirement, when overall income sources might be lower – thereby paying a lower rate of income tax later on.
Roth IRAs, on the other hand, are retirement accounts that provide no tax relief at contribution, but permit earnings to be withdrawn tax-free at retirement, as long as the distribution meets the qualified distribution rules.
If individuals believe that they are taxed more favourably today than they will be in retirement, then a Roth IRA can provide a tax-efficient way for them to save.
Under these plans, unless certain exceptions are met, the earliest age at which the individual can take their benefits without penalty is age 59.5. Distributing prior to age 59.5, without meeting an exception, generally results in an early withdrawal penalty of 10% on top of any income tax chargeable.
It’s important to note here that while Roth IRA distributions can begin from the age of 59.5, there are no required distributions from a Roth IRA. The situation is different for those with 401ks and traditional IRAs, as both have required minimum distributions (RMDs) of 70.5 years. RMDs, which are calculated using an annuity table published by the Internal Revenue Service, and IRA year-end account values, are the minimum amount that must be withdrawn each calendar year by the account-holder in question.
(The fact that Roth IRAs do not have the same RMD requirement from age 70.5 that traditional IRAs and 401ks do can make a Roth IRA an interesting tool for facilitating the transfer of assets to beneficiaries.)
Role of US/UK tax treaty
With respect to the question of whether this client we are talking about would owe tax on her Roth IRA, assuming she is old enough to cash it in and did so, the first thing to mention is that there is a tax treaty between the US and the UK, which determines which country has primary taxing rights of pension income.
Typically, unless a lump sum distribution of a pension is taken, the primary taxing rights of the distributed pension income resides with the country of residence.
In the instance a lump sum distribution of a pension is taken, the primary taxing rights of the distributed pension income resides with the country where the pension scheme was established.
As a result, the taxing rights in this scenario depend on how pension funds are distributed.
If, for instance, this American woman is living in the UK, and would be UK tax resident at the time of distribution, and she does not take a full distribution, then the UK would have primary taxing rights with respect to the pension distribution. If she chooses to take a full distribution, then the US would retain primary taxing rights.
If, though, as is also apparently the case here, the individual is also a US citizen, then, even in the scenario where the UK has primary taxing rights, the US retains the right to tax the distribution as well.
However, if taxes are paid in the UK, the woman will be able to claim an offsetting foreign tax credit on her US tax return, to reflect the taxes already paid. As a result, no double tax is incurred.
In the case of a Roth IRA, the tax-free nature of a qualified distribution is respected under the Income Tax Treaty between the US and the UK.
As such, provided the distribution meets the qualifying rules, this woman, the spouse of the questioner’s client, should not be subject to income tax on the distribution in either the US or the UK.
Generally, a distribution from a Roth IRA is considered qualified if both of the following two categories of requirements are met:
(1) It occurs at least five years after the Roth IRA owner established and funded his or her first Roth IRA (the five year period begins with the first day of the year for which the first contribution was made); and
(2) It is distributed under one of the following circumstances:
• The taxpayer in question is at least age 59.5 when the distribution occurs
• The taxpayer plans to use the distribution to buy or rebuild a first home for themselves, or for a qualified family member. This is limited to $10,000 per lifetime.
• The taxpayer becomes disabled before the distribution occurs
• The taxpayer beneficiary distributes the assets after taxpayer death
If both categories of requirements have not been met, the distribution is considered non-qualified. However, any penalties may still be waived if once of the exceptions are met.
In most cases, it is worth an individual seeking qualified tax advice from a dually qualified US-UK tax adviser, who can apply the treaty to their personal circumstances and ensure optimal advice is received.
The above article does not take into account the specific goals or requirements of individual users. Advisers should carefully consider the suitability of any strategies, along with an individual’s financial situation, prior to making any decisions on an appropriate strategy. Maseco Private Wealth is not a qualified tax adviser and individuals should seek separate advice on their tax position with a suitably qualified tax adviser.
Maseco LLP, trading as Maseco Private Wealth, is authorised and regulated by the Financial Conduct Authority in the UK, and the Securities and Exchange Commission in the US. Neither the Financial Conduct Authority nor the Securities & Exchange Commission regulates tax advice.
Readers who have technical and/or regulatory questions they would like Andrea Solana or other experts to answer, in print, are invited to contact Helen Burggraf at [email protected]