This is the first in a series of posts, each focusing on one type of account and how it might be useful to an American living in the UK. A full list of all accounts covered is on the Account Options page.
These posts will all follow the same general format, and should give you a basic understanding of what the account is, how you might use it, and any particular drawbacks it might have.
You’ll be auto-enrolled in a UK pension if you’re an employee anyway, and it turns out to be the best first option for long term investing. You get free money from the employer match, tax advantages in the US and UK, and no PFIC worries.
#1 priority up to the maximum employer match – free money! After that, it’s still probably the top priority for long-term investments, with the Roth IRA as the other contender, at least until you reach the max employer contribution.
UK employers are required to offer a pension and auto-enroll you (you can opt out if you really want). They’ll also pay at least 3% if you contribute 5% of your salary – many offer higher matches, but that’s the legal minimum. You won’t have one if you’re self-employed, but a SIPP (Self-Invested Personal Pension) is supposed to be the similar option. You can’t contribute to a pension after age 75.
The exact options will depend on the provider and the exact plan that your employer selects. Usually, you’ll be looking at a variety of funds – stock, bonds, UK, world, etc. Hopefully, you’ll have options for low-cost index funds and maybe target date funds.
PFIC rules don’t apply here, because it’s within a “pension scheme” as defined by the US/UK tax treaty. That’s good, because you probably won’t have any options that aren’t PFICs!
Your employer will offer a match of at least 3%, although possibly higher. You can choose to invest this match however you like, as well.
Risk & Return
Entirely depends on the investments that you hold within the pension. Your capital is at risk, there’s no guarantees.
You can’t withdraw any money (contributions or gains) before age 55 – this is going up to 57 from 2028, although existing pensions might be grandfathered in, it’s not clear yet. There are only extremely limited exceptions, stuff like a terminal illness with less than a year to live – otherwise, you face stiff penalties, like 55% taxation.
You don’t have to withdraw when you reach 55/57, and you can keep contributing until you reach 75.
When you do want to withdraw, there are three primary options, although not every plan offers all the options. You can move to a plan that has the option you want, though. You can also mix and match the options, to some extent.
- Purchase an annuity – this gives you lifetime guaranteed income, in exchange for your money now. Typically, when you and possibly your spouse die, there’s nothing left, the annuity provider keeps it.
- Cash – you can do whatever you like with the cash at that point. Spend it, put it in a bank account, invest in another investment account, etc.
- Flex-access drawdown – keeps the funds invested and you take cash from the investments. You might change your asset allocation to focus on income instead of accumulation, but that’s up to you.
The UK has a limit of £40,000 per year (2021), with a lifetime cap of £1,073,100 – this cap includes both contributions and growth. Exceeding the lifetime cap results in punitive taxation at 55%, so you want to stay under it. The annual and lifetime limits are shared with any individual SIPPs.
There’s also a tapering of that £40,000 limit for high incomes above £240,000. More details here.
Here’s where it gets tricky – due to the way the US/UK tax treaty works, the US applies the same limits to a UK pension that it does to a corresponding US plan, like a 401(k). For 2021, those limits are $19,500 for your individual contributions (plus another $6,500 if you’re 50 or older), and a total of $58,000 for employer and employee contributions. You’ll want to stay under these to preserve the US tax benefits.
Another twist – if you invest more than the employer match, the amount above the match may be treated as a “foreign grantor trust” by the IRS. These are subject to PFIC rules and additional complicated tax forms for a trust. There are a variety of opinions online, and I’m not confident enough in the intricacies of these rules to have a strong opinion. This results in three options:
- Safe but limited: don’t contribute any more than your employer, so there’s no worry about any foreign grantor trust implications.
- This is what I do – my employer will contribute up to 8% if I contribute 5%. I contribute 8%, so get that 8% match. It so happens that this is about as much as I want to contribute to my pension anyway – since it’s locked away until 55/57, I want my savings over this amount to go to more accessible accounts for my earlier FIRE years.
- Safe but painful: contribute over the employer match and file your US taxes as if the extra contributions are a foreign grantor trust. This means filing the extra forms both for a PFIC (since you probably can’t pick any investments that aren’t PFICs) and the trust. This is complicated enough I won’t cover it further, but it might be something you want to explore.
- Riskier: take the view that the additional contributions are not a foreign grantor trust but still part of the pension, and subject to that more favorable treatment. If the IRS disagrees with you, it could get ugly – would recommend speaking with a professional if you want to go down this route.
Completely depends on the provider. Some are low cost – for the UK, anything under about 0.5% is pretty good, as a combined total between overall management charges and fees from the underlying investments. Others are much, much higher.
Unfortunately, you’re pretty limited by whatever your employer offers, short of lobbying them to find a better plan. If their fees are really high, you probably don’t want to contribute any more than the minimum to get the full match (i.e. if they’ll do 8% for a 5% contribution from you, just do the 5% and no more).
You can transfer your pension after you leave employment to escape high fees, or just to consolidate them. Some plans will offer partial transfers, so you can move your money out while still employed – unfortunately, it seems like the kinds of plans that have high fees also tend not to have this option.
UK Tax Treatment – Contributions
Your UK taxable pay is reduced by however much you contribute, and your employer’s contributions are tax free to you. For example, if you make £55,000 per year but contribute £5,000 to your pension, you only pay income tax on £50,000.
This is really useful if you’re near the transition point from the 20% basic rate to 40% higher rate tax brackets – this is at £50,270 for 2021/22. In the example above, because you get your income under £50,270, you’re keeping £4,730 from being taxed at 40%.
Many employers also offer “salary sacrifice”, which means the contribution comes out of your pay before you ever see it and also saves you National Insurance (NI) taxes, which can be up to 12% for incomes between and £9,500 and £50,000.
UK Tax Treatment – Withdrawals
Generally, the first 25% of your withdrawals are tax free, and the remaining 75% count as taxable income in the year your receive them. Ideally, this is in a year when you’re already retired and don’t have huge amounts of other income, so you can keep this in a lower tax bracket at 0% or 20%, rather than the 40% or 45% you might have been subject to in employment at higher salaries.
The exact way the 25% tax free portion works out get complicated and depends on which withdrawal option you choose. I’ll do a future post on withdrawal planning, but the short version is that you get a UK tax break on about 25% of the value of the fund.
US Tax Treatment – Contributions
Because of the way the US/UK tax treaty works, you get to pick how the US treats your UK pension contributions.
- Default Option:
- Your contributions and your employer’s contributions are US taxable income in the year that they occur.
- However, you probably pay enough UK tax that your Foreign Tax Credits will wipe out any taxes you’d owe to the US, so you don’t actually have to pay anything.
- Now that the contributions have been “taxed” by the US (even if you didn’t actually pay anything), the withdrawals won’t be taxed. This is very similar to a Roth 401k in the US.
- Tax Treaty Option:
- You can elect to exclude your and/or your employer’s contributions from your US-taxable pay.
- In a typical tax situation, this won’t change what you owe (or don’t owe) to the IRS in a given year, although you’ll probably accrue more Foreign Tax Credits that you can carry forward for up to 10 years. But you may never have a chance to use these, if you remain paying UK income tax.
- You’ll owe US tax on the withdrawals, similar to how a Traditional 401k works in the US. Whether you actually need to pay anything will depend on your combined US/UK tax situation at retirement, but there’s a higher chance you owe something.
- If you want to take this option, you must specifically tell the IRS by including Form 8833 in your US tax return.
US Tax Treatment – Withdrawals
This depends on which option you picked for the contributions.
- If you paid taxes on your and your employer’s contributions, there won’t be any tax due on withdrawal.
- Update 15Apr21: I’m now less convinced of this interpretation – it could be that there aren’t taxes on the contributions upon withdrawal, but the gains are still taxed as income. Needs some further research to clarify this.
- If you excluded the contributions from your taxable income, the withdrawals will be included in your US taxable income. You may be able to take the same 25% tax free that the UK allows, this depends on your reading of the tax treaty and there seem to be a lot of different interpretations.
Either way, your earnings will be tax-deferred, if not tax-exempt – no tax due on gains as you go along, until you withdraw.