I’m working on a series of posts about retirement withdrawal strategies and managing US and UK taxes in retirement, and I keep drafting a comment that “I’ll do a post on Roth conversions in the future” – I’m just going to do it now 🙂
There’s already a lot out there about a Roth Conversion Ladder – I recommend this Mad Fientist post. The quick and dirty for Americans who live in the US is:
- Start with a Traditional IRA – this can be from contributions to the IRA, or from rolling over your 401(k) (or similar, like a 403(b) or TSP) to a Traditional IRA. There’s no tax or penalties on this rollover.
- Convert some or all of your Traditional IRA to a Roth IRA. This is taxable – the amount you convert gets added to your US taxable income and is taxed like wages, not capital gains (makes sense, since you previously deferred tax on the income you used to fund the 401(k), or took a tax deduction for contributions to the Traditional IRA – now the IRS gets paid).
- If your other taxable income is low enough, the tax rate might be 0%, though
- Wait five years, for your conversion money to turn into contributions within your Roth IRA
- You can do more conversions in following years while you’re waiting
- After five years, you can withdraw the conversions tax and penalty free – they’re now treated as Roth IRA contributions.
This way, you can do two important things:
- Get to the money that’s locked away in your Traditional 401(k) or IRA before you turn 59.5 – this can help you bridge from early retirement to a more typical retirement age.
- Gets the money out of the grasp of Required Minimum Distributions. RMDs are a ticking time bomb in your Traditional 401(k)/IRA.
Of course, this assumes that you already have Traditional IRA or 401(k) savings when you move to the UK, or build them up when you’re in the UK (less common). If you don’t, this won’t help you much, I’m afraid.
Side Note: Required Minimum Distributions
Until I started the research for this post and the upcoming series on withdrawal strategies, I was vaguely aware of RMDs but kind of thought of them as a problem to worry about for the future, not too big a deal. Turns out, they’re potentially huge!
Quick example: say you retire at 52 with $250,000 in your Traditional 401(k) or IRA – pretty reasonable if you maxed out your 401(k) for several years in the US, then moved to the UK and let it grow untouched. You still don’t touch it until you have to take RMDs at 72 – at only a 5% real growth rate, that’s now more than $600,000. When you turn 72, you have to take over $23k a year out of that, and that only grows every year. Social Security and the State Pension could easily fill your UK personal allowance (£12,300 – can’t share it with a spouse), so now you’re paying 20% tax on all of that RMD – $4,600 a year and climbing. If you live to 94 (and you have about a 25% chance of living that long if you’ve made it to 72), you’ll pay over $165k in UK taxes on your RMDs:
With Roth Conversions, you can anticipate and manage RMDs, instead of being stuck with whatever you get at age 72. With the right planning, you can get the RMDs to match the amount you actually want to take out, or you can get your Traditional balance to zero and not worry about them at all (there are no RMDs on Roth balances).
Done right, you’ll manage the tax on the Roth Conversions, so that instead of paying 20% you pay 0% or a smidge more – that’s $165k more you can spend, pass on, or do whatever you want with.
Roth Conversions and the UK
Everything above applies to Americans in the US, but how does the UK treat Roth Conversions? I have very good news (probably): Roth Conversions are completely tax free in the UK.
I say probably, because, while I completely understand the logic, and have found numerous reports of people actually doing this, there’s nothing in black and white from HMRC that clearly says yes. If you have any doubt, seek professional advice – with the sums that could be involved if you have a large 401(k), you don’t want to mess this up.
The logic is fairly straightforward, thinking back to our exploration of the US/UK tax treaty:
- Article 18 Paragraph 1 says, in part: “income earned by the pension scheme may be taxed as income of that individual only when…it is paid to…that individual from the pension scheme (and not transferred to another pension scheme) (emphais mine)
- Article 18 Paragraph 1 is not excluded by the Savings Clause
- A transfer from a Traditional IRA to a Roth IRA is a transfer from one pension scheme to another.
There are some other arguments that get to the same point, mostly using the lump sum clause – this is the one that holds the most water to me, though.
There’s nowhere to include the conversion in your Self Assessment, but I’ve seen people put a note along the lines of “During the yyyy tax year, I transferred a lump sum from my Traditional IRA Pension Fund to my Roth Pension Fund totaling $xx,xxx.xx. Since this is a transfer of a lump sum between pension schemes, it is exempt from UK tax and has therefore not been included in this return.”
It seems prudent to include some kind of statement, so that you can never be accused of trying to hide it if HMRC decides they don’t agree that Roth conversions aren’t taxed in the UK.
I’ve also seen some advice to do the conversions at most every other year, and not in the same value every time. This is based on an argument around the conversions being a “lump sum”, which isn’t taxed by the UK. The arguments aren’t mutually exclusive (can be both a transfer and a lump sum) – if you’re feeling cautious, there’s not much harm in spacing out the conversions in different values, anyway.
Using Roth Conversions
What does this mean for you? It means that if you have significant savings in a 401(k) or Traditional IRA, you can convert it into a tax-free Roth IRA, without paying UK taxes and, through some prior planning, paying no or minimal US taxes.
The amount of the conversion winds up in your taxable income on your US tax return, before any deductions. If your total taxable income is less than the standard deduction, you’ll pay nothing. Depending on your specific situation, you may be able to go above the standard deduction and cancel it out with credits, still paying no tax. Or even if you pay taxes, you start in the 10% bracket, not the 20% basic rate in the UK.
I’ll look at how this fits in to an overall retirement withdrawal strategy in the upcoming series, but it can be a key part of reducing tax if you have a substantial Traditional balance.
Advanced Mode: Roth Conversions and Foreign Tax Credits
I feel pretty confident about what’s above – this section is where I feel like we’re on a little bit of uncertain ground. Basically, there are some sources saying that not only can you pay zero UK tax on your Roth conversion, but also can use Foreign Tax Credits (from other income) to offset some or all of the conversion on your US taxes, even if they’re over the standard deduction.
The typical American in the UK who is earning an income will have excess general category Foreign Tax Credits, because the UK tax on earned income is essentially always higher than the US tax. The excess FTCs can be carried over for up to 10 years – this is all very clear. Where it gets less clear is whether you can use these general category FTCs against Roth conversions.
There’s an argument that this only applies to the portion of your conversion that is composed of contributions form foreign source general category income. This paper spells that position out pretty clearly, and it makes logical sense – you’ve contributed foreign income to this pension and were already taxed on that income, so you can use the FTCs from that tax on the conversion. This feels like reasonably solid ground, although limited applicability – it only helps for the portion of your Traditional IRA or 401(k) that you funded from foreign earned income. That may well be zero (it is for me).
There’s another argument that you can use any general category FTCs against the whole of the conversion, not just any portion that’s attributable to foreign earned income. I can’t find anything clearly saying you can’t do this, but it feels a little dicey. You’re basically saying that you haven’t paid foreign income tax on either the income that funded the 401(k)/IRA (because it’s from US income before moving to the UK, for our purposes), and you didn’t pay foreign income tax on the conversion itself (because it’s not taxable in the UK), but you’re going to use FTCs that came from other income to offset the US tax on the conversion. It feels like cherrypicking, trying to make the US tax system that doesn’t quite make sense.
I’m not willing to dismiss it out of hand, though – if any of you have a clear argument for how this works, I’d love to hear it!
Side Note: 72(t) SEPP
If you read the Mad Fientist article at the top, he also discusses a 72(t) Substantially Equal Periodic Payments (SEPP) option, instead of a Roth conversion, so that you can withdraw from a Traditional IRA prior to reaching age 59.5.
Three quick thoughts on this option for Americans in the UK:
- I’m confident this is UK-taxable income – it’s clearly a periodic payment, right there in the name. I don’t see any reason why it would be penalized beyond being normal income – still gets taxed at the higher UK tax rates, though.
- I could make an argument that it shouldn’t be US-taxable income, because it’s a periodic payment from a US pension to a UK resident. In practice, it doesn’t really matter – the UK tax will almost certainly be higher than the US anyway, so Foreign Tax Credits would wipe it out.
- It helps you get money early, and in so doing reduces your Traditional balance, helping with the RMD time bomb.
Therefore, it’s probably an option for getting to your money early, if you a) want to deal with the complexity, b) have a pretty good idea how much you’ll need and don’t expect that to change, and c) don’t mind paying the higher UK tax on it.
For me, I think Roth conversions are the better deal, due to paying US rather than UK tax, and are simpler.