US & UK Tax on Traditional to Roth Conversions

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:

  1. 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.
  2. 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
  3. 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
  4. 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:

  1. 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.
  2. 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.

11 thoughts on “US & UK Tax on Traditional to Roth Conversions

  1. I’m not sure I follow your logic regarding the (non) UK taxation of Roth conversions. You say it’s not a distribution because it’s a transfer, but then surely taking money out of a Roth will therefore be a distribution from a pension scheme and so will be taxable in the UK at that time. My assumption was that Roth conversions would be taxable in both countries, but then the Roth would become like an ISA but works in both US and UK. Your suggestion sounds too much like having your cake and eating it. You’ve spent more time studying the treaty, so perhaps you are right, but it sounds high risk to me.

    I’ve considered the logic of using Roth conversions for my dad, but he’s basically fallen into the very trap you describe. i.e. withdrawals from the IRA are potentially bumping him into a high tax bracket in the UK. He really should have started converting more to Roth when he was younger.

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    1. I didn’t mention the tax on Roth withdrawals, but it does seem pretty clear that the UK has to respect the US treatment of a pension scheme, so for a Roth IRA there’s no tax (Article 17 Paragraph 1b). I completely agree – it sounds a lot like cakeism, but I’ve found numerous people who are completely up front about the conversion on their Self Assessment and never get questioned. I think it’s one of those where the nuances really matter.

      Part of the curiosity is that the “new” treaty (2003 instead of 1975) included specific language around lump sums to avoid people completely avoiding tax. The old treaty said that a lump sum was only taxed in the country of residence, and the UK doesn’t tax lump sums anyway, so people could just move to the UK and take the lump sum tax free – now, you’ve got to at least pay tax to the US, unless you can stay below the standard deduction or use FTCs. https://www.gov.uk/hmrc-internal-manuals/double-taxation-relief/dt19876a I don’t like how many of the arguments flip between lump sums and transfers, though – it seems like HMRC has accepted the argument, but it would be interesting to see it in court.

      I’m working on the bigger withdrawal strategy series, and it really opened my eyes today when I modeled how huge RMDs can be and how much Roth conversions can help. For a reasonably typical FIRE portfolio, actively planning for RMDs using Roth conversions can be the difference between £30k and £300k in taxes over a 40 year retirement. Without Roth conversions but actively trying to manage RMDs, I could get the same portfolio down to around £110k in taxes – good, but still way more than with conversions.

      Once you hit the RMDs I can’t see a way out – between RMDs, SS, and State Pension, you can easily be in the higher rate bracket and those never really stop.

      The only thing I can think of, and you’d have to run the numbers, if is it’s worth it to do a big conversion in one year and then drop under the personal allowance, or at least into the basic rate, due to the lower RMDs from the smaller balance. Not sure if that would actually work, but worth looking at. Certainly won’t escape all the tax that you could with conversions earlier on, unfortunately.

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      1. Yeah, I get lost pretty quickly once arguments about lump sums are made, especially considering UFPLS, moving residence, etc. I just don’t think the treaty was designed to handle all the various nuances. I’m sure it’s about time the treaty was updated, but who says it would be improved in our favour?! David Treitel once said he didn’t want to ask HMRC about a particular treaty position, for fear they would give him the answer he didn’t want! I think he prefers the ambiguity!

        My dad has said he’s happy to leave his IRA to his kids. Given our relative ages, we will probably be in a lower tax bracket than him for a while, so withdrawing from a smallish inherited IRA for up to 10 years will be ok. As you say, if you live for a long time with a lot still in an IRA then the RMDs ramp up fast and there’s no escape.

        Another drawback, from what I can tell, is that IRAs still count as part of your estate with regard to IHT in the UK (unlike UK pensions), so you will reach the IHT allowance a lot quicker. I kind of hoped this wasn’t the case, but I haven’t found anything that refutes it..

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      2. I see where David’s coming from, and agree – I can’t imagine that they would necessarily help individual people with any revisions. Maybe in some cases, but not in others, and individual situations are so variable that closing one “small loophole” could have a huge impact – think if they clarified that SIPPs are NOT pensions, or that Roth conversions are UK taxable, etc.

        I think you’re right on IHT – hadn’t put that piece together yet, but just reinforces that you want to get IRAs drawn down early on, especially Traditional.

        And of course, in the big picture, all of these are very much first world problems, if not 1%er problems – too much money and we don’t want to pay tax on it! I’ll still keep trying to minimize my tax burden within the law, but if I wind up paying a little more that I might have been able to avoid with a lot of hassle and ambiguity, I won’t lose sleep over that.

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      3. I totally agree with your last point about the payment of taxes in general. It’s easy to get carried away with trying to be tax efficient and lose sight of the bigger picture. I have have no problem with paying the higher rate of tax in the UK. I actually think the US tax rate is too low, but it probably reflects a stronger distrust in government. It’s frustrating how difficult it is to just obey the law. Most people, at least in the UK, never even need worry that their taxes might be calculated incorrectly or that they might accidently face some massive fines. The easiest way to reduce tax is to be poor, but nobody wants that. The hurdles that face multinational individuals, especially US citizens “abroad” trying to save for retirement, will probably never make sense or be truly “fair”. But that doesn’t mean that we should throw up our hands and give up, or unnecessarily pay huge sums to advisors. I feel sorry for those people on much lower means that have only just discovered their obligations and how much trouble they could potentially be in.

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      4. Agreed – I don’t think the tax rates in either country are “unfair”, it’s the complexity and ambiguity that borders on unfair. And so do a few of the specific elements – the intersection of PFIC, HMRC non-reporting, and MiFID/KID is pretty unfair. But we can work with that.

        The fact that none of this is clear to people who find themselves in this situation, often through no fault of their own, is pretty unfair, and neither the IRS or HMRC make it easy to figure out. People who were born abroad or moved as young children, even people who move as adults but only ever had simple taxes in the US – they all find themselves in this world of complexity, where innocent mistakes can be hugely costly. That’s one of the things that led me to start writing down my research on this site. I was going to do most of this myself, for my own learning, and it felt only fair to share it. I can’t make it much less complex, but can try to explain it and at least help people figure out what works for them.

        The frustrating part is that the path of least complexity and minimal ambiguity potentially gives up a lot of benefit. For an employed person, it’s basically UK pension up to the max employer contribution, and that’s it. Anything else relies on slightly ambiguous treaty positions, requires a semi-fictitious US address, and/or requires the complexity of individual stocks and reporting those to the IRS. For somebody who wants to retire at a “normal” age, that might be enough, but it won’t get you to FIRE.

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    2. Forgot to mention, the other strong supporting element for the argument that Roth distributions aren’t taxable in the UK is the US technical explanation of the treaty (which obviously isn’t legally binding on the UK, but haven’t seen anything that says HMRC disagrees with it, and if the IRS lawyers interpret it that way, it gives me a reasonably good feeling). https://www.treasury.gov/resource-center/tax-policy/treaties/Documents/teus-uk.pdf

      The explanation for Article 17 paragraph 1:

      However, the State of residence, under subparagraph (b), must exempt from tax any amount of such pensions or other similar remuneration that would be exempt from tax in the State in which the pension scheme is established if the recipient were a resident of that State. Thus, for example, a distribution from a U.S. “Roth IRA” to a U.K. resident would be exempt from tax in the United Kingdom to the same extent the distribution would be exempt from tax in the United States if it were distributed to a U.S. resident. The same is true with respect to distributions from a traditional IRA to the extent that the distribution represents a return of non-deductible contributions. Similarly, if the distribution were not subject to tax when it was “rolled over” into another U.S. IRA (but not, for example, to a U.K. pension scheme), then the distribution would be exempt from tax in the United Kingdom.

      Nothing in there about Roth conversions, though.

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