UK Pension Withdrawal Options

Continuing with our interlude from the Withdrawal Strategies series – this is the second of three posts:

  • Required Minimum Distributions from Traditional IRA, 401(k), etc. and how to manage them
  • UK Pension withdrawal options
  • Managing the Lifetime Allowance (I added this one because it was going to be too long to fit in the others!)
  • RMD vs Lifetime Allowance Horse Race – how to deal with both of these at the same time

After that, we’ll get back to the Withdrawal Strategy series.

Why are pension withdrawals so confusing?

Compared to US IRAs and 401(k)s, the UK makes this a complicated topic with a lot of jargon – stuff like “flexi-access drawdown, “uncrystallised funds pension lump sums,” “money purchase allowance”, and “benefits crystallization events.” Plain English, right?

And of course, all the advice you find about pensions is largely focused on UK taxpayers only – not considering Americans in the UK. There are some articles on US tax on UK pensions, but they tend to get very focused on individual details, not the big picture.

Fair warning: there is a lot of grey area here, regarding US tax on UK pensions. I’ll explore that grey area a bit so you’re aware of the questions, but I don’t have solid answers.

Also, some assumptions:

  • We’re only talking about defined contribution pensions here, whether a workplace pension or a SIPP (the withdrawal rules are the same)
  • We’re talking about a substantial pension, say £30,000+ (there are some simpler rules for small ones that I won’t cover today)
  • We’re assuming you’ll live for a fair amount of time after being able to withdraw your pension at age 55 or 57 – there are some special rules if you’re terminally ill or die before age 75 that I won’t cover
  • Your pension plan allows for all the withdrawal options, and doesn’t have any other limits, like ages when you need to start taking withdrawals, etc. Check your pension documentation.
  • We’re only talking about post-A day (post 2015) pensions here
  • You’re using Foreign Tax Credits for US taxes, not the Foreign Earned Income Exclusion. FTCs are usually better for Americans in the UK, anyway.

We’ll start with a quick reminder of how the US taxes UK pensions, go through a few key concepts, then explore the withdrawal options considering both the UK rules and the US impacts.

US Tax on UK Pensions

Big warning – this is not an especially clear tax topic, and the various interpretations can have very significant impacts. 80% of the time, the interpretation doesn’t really matter – you wind up paying no US tax due to Foreign Tax Credits. But the 20% gets confusing – if you find yourself in that 20%, I’d recommend some professional advice.

Americans have two options for how to report their contributions to UK pensions – this impacts how they are taxed on withdrawal:

  1. By default, the IRS expects you to report your contributions and any employer contributions as taxable income, just like your wages (line 1 on your 1040). You probably won’t pay any US tax though, because Foreign Tax Credits more than offset your US tax.
  2. You can claim a treaty-based position (Form 8833) that your contributions and any employer contributions should be excluded from your taxable income, so you don’t even calculate the tax on them. You still don’t pay any US tax, and build up FTCs faster because you’re paying the same UK tax but using less of it to offset a smaller US tax.

Option 2 has the simplest US tax treatment on withdrawal – all your withdrawals are taxed as US income (with some caveats around the UK 25% tax free). This is basically the way a Traditional IRA or 401(k) works, for comparison.

Within Option 1, I’ve seen two interpretations on how this impacts your US taxes on withdrawal:

1a. Basically the same as Option 2, all your withdrawals are taxable income. However, you have a stepped-up basis to reflect the fact that your contributions have already been taxed, even though you probably didn’t pay anything. So very roughly, if your balance at withdrawal is 25% contributions and 75% gains, you’ll only be taxed on the 75% gains. Again, you can use FTCs to offset US tax – you likely don’t pay anything (unless you aren’t paying UK tax – more on that later).

1b. The tax treaty (Article 18 paragraph 5c) says that contributions to a UK pension scheme are treated by the IRS as if they were made to a generally corresponding pension scheme in the US. The logical corresponding pension scheme where the contributions are from post-tax money is a Roth 401(k) or Roth IRA. Thus, all the withdrawals are tax free, no need to worry about FTCs.

I like Option 1b better, but I’m not confident enough (yet) to fully rely on it. So this post will focus on Option 1a and Option 2 – if you’re confident in Option 1b, you can pretty much ignore every upcoming mention of US tax, because there isn’t any.

Update 26May21: I’m less and less convinced by option 1b these days, although I welcome any arguments! I wrote a followup post going into more detail on taxes on UK pension withdrawals.

25% Tax Free

The UK government allows you to take 25% of your pension tax free, called a “pension commencement lump sum” (PCLS). The other 75% gets taxed as income (like wages). This applies across all the different withdrawal options, although in different ways – you can take it all up front, or spread throughout withdrawals. It is limited to 25% of the Lifetime Allowance, as well – withdrawals over the Lifetime Allowance don’t get 25% tax free (more on that in a minute).

The US position on this 25% tax free is unclear – I have seen some pretty passionate arguments both ways. I am not enough of an expert to make any recommendation here and I’m not convinced either way.

Here’s some of the arguments I’ve read – you don’t need to read them to keep going with this post, but they may help you decide how you want to plan:

For the sake of conservatism, I’m planning as if the US does tax the 25% tax free amounts. In most scenarios, Foreign Tax Credits mean there isn’t any US tax due, but it does limit some of the withdrawal possibilities. For example, if you were only a UK taxpayer, you could take 25% of your pension tax-free up front – if you do that as a US taxpayer, that could be a big chunk of US tax.

If the US position on the 25% tax free becomes more clear, I’ll revise my planning – it can basically only get better than my current assumption, and even that isn’t too bad, just has to be planned for.

Lifetime Allowance

This one gets complicated, but the basic gist is that if your pension value goes over £1,073,100 (2021 value – changes over time but not necessarily with inflation), you get to pay a penalty tax of 25% on top of your income tax for the value over that limit. Rather than me trying to explain it, go see this excellent post from Monevator for all the gory details, then come back.

How do you avoid the Lifetime Allowance? Either don’t save enough in your pension that you’ll never exceed the Lifetime Allowance, including compound interest, or take enough money out of your pension early in retirement to avoid going over. I’ll look at these options in the next post.

Crystallisation

What do crystals have to do with pensions? Nothing – crystallisation is just a term that defines whether or not a part of your pension has been “tested” against the lifetime allowance.

This is one of those things that’s kind of ludicrously complex (there are 13 different Benefit Crystallisation Events!), but the basic concept isn’t too bad:

  • Before you’ve taken any money from your pension, your entire balance is “uncrystallised”
  • At each Benefit Crystallisation Event, some (or all) of your balance gets “crystallised” – that means it gets tested against your Lifetime Allowance. Typically, the amount crystallised is the amount you withdraw, use to buy an annuity, or designate as “drawdown”
  • If this crystallised amount, added to any previous crystallised amounts, puts you over the lifetime allowance, you pay the 25% penalty (technically 55% for a lump sum, but that is essentially including income tax at 40%)
  • When you reach age 75, there’s a specific Benefit Crystallisation Event on any so far unused balance. You’ll pay the 25% penalty at age 75 if your balance plus any previously crystallised amounts are over your Lifetime Allowance. However, from that point forward, your entire balance is crystallised, and you don’t face any more Benefit Crystallistion Events.

If you want to know more, here’s HMRC’s Pensions Tax Manual on the topic – some light bedtime reading. I also found Aegon’s article on the topic to be comparatively easy to read.

What are the withdrawal options?

The helpful UK government PensionWise website calls out 6 different options. All of these apply to withdrawing your money between the age when you can first access your pension (55 or 57), and before age 75. After age 75, you can still get your money but you stop caring about the Lifetime Allowance.

The options:

  1. Leave it be – just let your pension balance grow until you want to take it.
  2. Annuity – take your 25% tax free and use the rest to buy a guaranteed income for life. Income from the annuity is taxable.
  3. Flexi-access drawdown – take a chunk (or the entire balance) as 25% tax free cash and invest the other 75%. Take a taxable income from that investment over time – if you take more than is sustainable, you may run out of money.
  4. Partial uncrystallised funds pension lump sums (UFPLS) – take a chunk as 25% tax free cash and 75% taxable cash. Take too many or too big of chunks and you may run out of money.
  5. Full balance UFPLS – take out your entire pension balance as cash, 25% will be tax free, 75% taxable.
  6. Mix and match – do some combination of all of the above.

Ruling out options

Two of those options are pretty unsuitable from a tax perspective:

Annuity: Assuming that 25% of the total value of your pension is not taxed in the UK but is taxable income in the US, that could be a very substantial lump sum, pushing you into higher US tax brackets for the year. The annuity income will then be out of your control – probably only UK taxed, but if Social Security and/or State Pension are filling your personal allowance, this will be at least 20% basic rate income. Plus, with interest rates as low as they are these days, annuities aren’t very attractive to me.

Full balance lump sum (UFPLS): Even just from a UK tax perspective, this one could be painful – in one year, you’re going to shove 75% of your pension balance into the income tax brackets. For any kind of a sizable pension, that’s a lot of tax – if your total balance is over about £67k, you’ll be paying some 40% higher rate tax. Over about £133k, you’re into the small but painful 60% bracket, and from about £200k on up, you’re paying 45%. £200k is hardly a massive pension if you’ve been saving for a decade or two, with some compound interest.

Because of the potentially big UK tax here, US tax is likely zero due to FTCs – but I don’t want to pay 45% tax to the UK, either!

This option could make sense if you have a small pension and just want to simplify things, like if you only worked at one employer for a couple of years and never consolidated pensions. It doesn’t make sense for a big pension that’s a substantial chunk of your retirement savings.

Non-Options

Two of the options aren’t really options at all, so we can move past them:

Mix and match: This is just reminding you that you can do more than one. You could take out an annuity with part of your pension, do an UFPLS lump sum with another part, put some into drawdown, and leave the rest invested. It’s very likely you’ll want to do this, but this option doesn’t tell you which options to mix, just that you can.

Leave it be: This is the default if you don’t choose to do anything else. Your money just stays in the pension and stays invested, hopefully compounding the whole time. This is great until you need the money, but doesn’t actually get you any money to spend in retirement.

If you’re in the fortunate position to have enough other savings to live off of, this might actually be the option you pick. A UK pension is a good place to leave money for later and maybe for your heirs, charity, etc. It doesn’t count as part of your estate, so there’s no concerns about inheritance tax.

The one thing to watch out for is the Lifetime Allowance test (“benefit crystallisation event”) at age 75. If your balance is over the Lifetime Allowance (£1,073,100 in 2021) and you just leave your money be, you’ll get hit with a 25% penalty tax on the the portion over the Lifetime Allowance.

Picking between two good options

That leaves us two good ways of actually getting to our money: Partial Uncrystallised Funds Pension Lump Sum and Flexi-Access Drawdown. Theoretically, these are quite different options, but in practice they may wind up pretty much the same. Let’s take a deeper look – we’ll start with the slightly simpler one:

Partial Uncrystallised Funds Pension Lump Sum (UFPLS)

That’s a really long name – let’s break it down a bit:

  • Partial: only part of your balance (not an official part of the name, I’m just using it to differentiate from taking your entire balance as a lump sum)
  • Uncrystallised Funds: the money comes from the “uncrystallised” part of your balance – from your pension itself, not from a designated drawdown fund. This means you have to have uncrystallised funds to withdraw from.
  • Lump Sum: this is a one off withdrawal, not a series of payments

Basically, you choose to take £x from your pension, get 25% of it UK tax free and 75% UK taxable. You can choose to do whatever you like with the money – spend it, invest in an ISA or brokerage account, etc. (you’re very limited on putting it back into a pension, to avoid making free money). The tax on the 75% is probably enough to provide enough FTCs to offset any US tax, if it’s payable.

Quick example, assuming your UK pension is fully US taxable: Withdraw £40,000 to fund spending for a year. Only £30,000 is UK taxable, let’s say all at the 20% rate, so that’s £6,000 in UK tax. If we assume that’s $56,000 of income ($1.40 to the £) in the 12% US tax bracket, that’s $6,720 due in US tax. Our £6,000 in UK tax translates to a $8,400 FTC, more than offsetting the $6,720 US tax liability.

You do have to be a little careful at higher withdrawal rates and especially if you’re filing as single or married filing separately in the US. A quick illustration: withdraw £50,000 to fund spending for a year. Only £37,500 of that is UK taxable – lets say it’s all at the 20% rate, so that’s £7,500 in tax. Say the withdrawal is $70,000 split 50/50 in the 12% & 22% US tax brackets, that’s a US tax liability of $11,900. £7,500 in FTCs is $10,500, leaving US taxes due of $1,400. You might have FTCs to carry forward to cover this, but otherwise you could owe real money to the IRS.

There’s no easy solution to this one, except keeping your withdrawals small enough to avoid US tax. A good reason to have multiple sources of income in retirement – you could withdraw some from your pension, some from an ISA (taxed as capital gains, not income), some from a Roth IRA (tax free), etc., so you can get the spending you want without paying excessive taxes.

Flexi-Access Drawdown

Another long name – this one is a bit confusing, because it’s really comparing this option to options that don’t exist anymore since the pension reforms in 2015 (at least not for new pensions – capped drawdowns are grandfathered in for some, but we won’t cover them here).

There’s a little more flexibility on this option – basically, you choose to designate £x of your pension as drawdown. You get 25% of it UK tax free, and the other 75% gets put into a crystallised drawdown account. In practice, this is just a different bucket within your pension, invested in whatever you pick (within the limits of what the pension offers). You don’t pay any tax on that 75% until you choose to take it out, then it’s taxed as income.

For a UK-only taxpayer, that sounds pretty good, I think. Take out tax-free cash when you need it, but then only take taxable money when you want to – easy to manage your income tax liability. But there’s a catch, for Americans paying tax on their UK pensions. If you take 25% tax-free, there’s obviously no UK tax paid. However, if that’s US taxable income, now you don’t have any FTCs to offset it – you owe the IRS your full US taxes on that income (unless you have enough FTCs to carry over, for up to 10 years).

In practice, that means that you probably won’t diverge too far from the 25/75 split of UFPLS, since that is right about the split that avoids US tax for most cases, barring somewhat large withdrawals. That’s sheer coincidence or good luck, nothing by design!

You might try to optimize your FTCs to take a little more out without paying US tax and not continuing to build up FTCs that you’ll struggle to use – honestly, I think this is more trouble than its worth and mostly has the same end result, but something to think about.

Quick illustration, if you’re interested: You designate £28,000 for drawdown. Take £7,000 as the 25% tax free. Take an additional £16,750 taxable at a UK 20% tax rate, resulting in £13,400 after tax of £3,350. Effective tax rate is 12% ($4,690). If you’re in the 12% US tax bracket, there no US tax because your FTCs exactly match your US tax liability. £4,250 remains crystallized in the drawdown account and will be fully UK & US taxable on withdrawal.

This gets even a bit more complicated if you’ve been reporting your pension contributions on your US tax returns – now your US tax liability is smaller because you’re only taxed on the gains, so you can take out more as income before you would owe any US tax. That calculation is beyond the scope for today – maybe I’ll look at it in the future.

Which is better, Lump Sum or Drawdown?

Honestly, for people who are liable for both UK and US tax on their UK pensions, I think it’s a tossup. You’re either stuck with the 25/75 split using the lump sum method (UFPLS), or you’re going to want to stay pretty close to it anyway to avoid a US tax liability if you’re using drawdown, which means they both do the same thing.

I think this one likely comes down to the nuances of your actual pension plan and provider, and maybe just whether their website makes UFPLS or Drawdown easier to do. From a financial and tax perspective, they’re basically identical.

In both cases, you probably also only want to withdraw money you’re actually planning to spend in the near term – maybe you’re doing withdrawals quarterly, annually, whatever. If you take more out than that, you’ll want to get some of it invested, but that’s kind of a hassle compared to just leaving it in the pension. An ISA is probably your best bet, but between transaction costs and needing to be in individual stocks to avoid PFICs, it’s still a faff.

There’s also a UK inheritance tax consideration. In general, your pension does not form part of your estate and is not subject to inheritance tax (typically, if you die after age 75, your heirs will be taxed on the income from the pension at income tax rates if they choose to take anything out; if you die before 75, it’s tax free to them but gets tested for the lifetime allowance first). However, once you take a withdrawal or income from your pension, that money is now subject to inheritance tax. The caveat is that money that is designated for drawdown still remains within the pension, and thus is still free from inheritance tax.

So if you’re doing some strategy where you designate a drawdown but don’t take all of it as cash, leaving some in drawdown, that might be helpful for estate planning. In practice, we’ve seen that you’ll probably want to take most of that 75% in drawdown as income, so you have FTCs to offset US tax on the 100%.

I’d be interested in feedback from any readers who have actually done a UFPLS or Drawdown designation – were there any stumbling blocks in practice that I’ve missed in theory? How easy was it actually to do?

In my next post, I’ll look at the Lifetime Allowance and some strategies for managing it, and follow that up with a post on trying to manage both the Lifetime Allowance and Required Minimum Distributions.

5 thoughts on “UK Pension Withdrawal Options

  1. My only hands-on experience of withdrawing from a UK pension was when I helped my dad close his small AJ Bell SIPP all in one go. So there wasn’t any need to explore any other options. I seemed to remember it took a little longer than expected to receive the actual payment, so just make sure you don’t pay for the retirement party until you’ve actually received the money. Also, I was confused as to why AJ Bell taxed the taxable portion (i.e. after receiving the 25% tax-free lump sum) at 30%. It may have been because my dad had never used PAYE in the UK before so didn’t have a tax code and AJ Bell (or HMRC) didn’t know what tax rate to use. In the end, we had to use his self-assessment tax return to pay the correct amount of tax. So you might want to think about the timing of any withdrawal and/or make sure that you’ve paid the correct amount of tax to HMRC before the end of the calendar year, so that you can include this on your IRS foreign tax credit form for that year.

    Also, I wasn’t entirely certain what category of income a pension withdraw goes into on the FTC form. Is it general category (like earned income) or passive income (like an annuity)? In the end I used the passive category – which seemed to work because I’m told he can expect his refund to arrive this week from the IRS. I also had to use Schedule 1 (Form 1040) to describe the pension withdrawal as line 8 “Other Income”. I made sure I described it as: “UK HMRC REGD PENSION DISTRIBUTION TO UK RESIDENT”. On the statement attached to Form 1116 describing the foreign tax paid I used “UK TAX PAID ON HMRC REGISTERED PENSION SCHEME DISTRIBUTION TO UK RESIDENT US CITIZEN, TAX TREATY ARTICLES 1,4,17,18,24 AND SAVING CLAUSE”. I rather doubt the IRS got around to reading this bit, but I just wanted to make sure they knew I would put up a fight if they had any problems with it!

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    1. I have read that often the first payment from a pension will get tax withheld at the emergency rate, sounds like that’s what happened – then you just get it back later. Basically the US system with withholdings and refunds, but that’s pretty foreign to most people in the UK 🙂

      Good point on the FTC categorization – I could kind of go either way with passive vs general. It’s passive in that a lot of it will be investment income, but general because some is tax-deferred salary, and it gets taxed at income rates, not capital gains. Or it might supposed to be some terrible mix where the contributions are general and the gains are passive. I haven’t come across any guidance – I think picking one and sticking with it probably works unless the IRS really decides to take an interest!

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