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Welcome

Thanks for finding my new site, focusing on FIRE (Financial Independence/Retire Early) for Americans who live in the UK, or want to.

This site grew out of an idea that I had after helping a number of people on both Facebook and Reddit. There is lots of information out there about how to invest for FIRE, and tons of information on both US and UK taxes, although somewhat less on how the two systems interact. It’s really hard to find something that ties it all together, and that’s really important for US citizens in the UK. Investing in a way that isn’t tax efficient can be hugely punitive (55%+ tax rates, massive fines for non-compliance with unexpectedly complicated tax filings, etc.).

I started putting a document together to summarize the basics of what you need to know. Once that document reached 40 pages (!), I realized I needed to either write a book or create a better site for it. That’s this site.

Next Steps

For starters, I’ll be moving the content from that initial document here, organizing and expanding. Those topics include:

  • Summary of each account option for investing (pensions, ISAs, IRAs, SIPPs, etc.)
  • High level review of real estate, inheritance tax, things to consider before you move, and the US/UK tax treaty

From there, I’ve got some ideas about other topics I’d like to explore, and will also post on more timely topics as they come up. I’ve started a list on this page – definitely welcome your comments on other topics you’d like to see!

Estimating Social Security for Americans in the UK

I’m back after a short break – a week on holiday in Cornwall, and another week just catching up. I’ll continue my withdrawal strategies series in due course, but this is another quick aside, which is related but not central to that series.

A lot of people in the FIRE community, especially on the younger side, tend to ignore Social Security completely in their planning. On one hand, I get that, and I do the same to some extent – I discount both programs by 50% in my planning. The fact that both of those will very likely exist in some form in another 3ish decades gives me some backup in case things go very wrong, and I think 50% is probably plenty conservative.

I do think it’s worth everybody having some sense of how much Social Security could be – even if not for spending planning, it’s worth considering for tax purposes, because for many people it will fill all or most of your Personal Allowance, especially when combined with any State Pension. But there are some complications that apply especially to Americans living outside the US:

  • Many of us won’t have the full 35 years of earnings
  • If you qualify for the UK State Pension (or other similar scheme), you’ll probably be subject to the Windfall Elimination Provision, reducing your Social Security payments.

So, I’ll walk through the three steps I’ve taken in order to estimate my own Social Security payments – I welcome any feedback on other ways of doing this, because it does get slightly long winded 🙂

If you haven’t read my intro to Social Security and State Pension for Americans in the UK, it’s probably worth glancing over that before diving into this post.

Step 1: Your Social Security Earnings Record

This one is pretty easy. First, log into your mySocialSecurity account (create one if you don’t have one yet). Annoyingly, the website is only open for part of each day – why a website can’t be open almost 24/7 is beyond me, but just plan around it.

When you get in, click on “Review your full earnings record now”:

Copy your record – we’ll paste it into a calculator in the next step. You may want to store your record in Excel or Google Sheets for easy future reference, especially if you want to do any planning when the Social Security website is closed.

My earnings are $0 because I live and work in the UK now – no need to pay Social Security taxes due to the totalization agreement, but I also don’t accrue any earnings history. My US earnings history is in earlier years, but didn’t want to post that!

For illustration, I’ll use an example earnings record. Let’s say that Jill earned $60,000 a year from 2010 to 2019, then moved to the UK in 2020 with zero earnings, and Jill is married to Jack, who earned $40,000 a year over the same time period. They were both born on 02 January 1985, and plan on working for another 20 years in the UK, qualifying for 57% (20/35) of the new State Pension.

Step 2: Your Primary Insurance Amount

Once you’ve got your Social Security earnings record, I recommend using the very useful Social Security calculator at ssa.tools. Note that this isn’t an official US government website, but I find it very useful and the security is such that I’m not worried about pasting my earnings record in, because it stays entirely on your computer (not that your earnings record is SUPER confidential, but probably not something you want out in the open).

Open up ssa.tools and click the big green “Get Started” button. The instructions on the site are pretty clear – you just need to paste your earnings history into the box. Here it is with our sample data for Jill:

Double check the numbers look good and press Yes. Put in your birthdate and then it brings up the report.

I recommend spending some time looking through this report – it does a great job of explaining how Social Security works, how future SS earnings would affect you (if you have any – you probably won’t live if you’re living in the UK, with a small caveat for self-employment).

Once you’ve had a look through, jot down your Primary Insurance Amount. If you’re married, repeat the process for your spouse.

In our example, Jill’s PIA is $1,103.10, Jack’s is $927.70.

Quick Aside – Social Security Bend Points

You may have noticed that Jill made 50% more than Jack every year, but her PIA is only 19% more than Jack’s. That’s because Social Security is intentionally tilted towards replacing a larger percentage of the income of lower income workers compared to higher ones. ssa.tools has a nice chart illustrating this, here’s Jack in green and Jill (almost) in blue:

There’s a more detailed explanation on the site, but the key is that “bend point” between 90% and 32%. That’s saying that both Jack & Jill get 90% of their “Average Indexed Monthly Earnings” up to a threshold (currently $996), but only 32% above that (and only 15% above $6,002 – that would mean about $72k in Social Security earnings over 35 years, or maxing out your SS earnings above about $142k for 18 years). So there are quickly diminishing returns to earning beyond the bend points.

This is actually a pretty good thing for many people who work in the US for 10 or so years before moving to the UK – you’ve gotten the most bang for your buck by filling up the 90% portion, even with only 10 years of work at a fairly modest wage ($40,000 is around the 34th percentile of US income, although would have been higher back in 2010).

Step 3: The Impact of State Pension & WEP

I really like the ssa.tools calculator, but one thing it doesn’t model is the impact of also receiving the UK State Pension. This triggers a Social Security clause called the Windfall Elimination Provision. There is another open-source calculator, Open Social Security, that handles WEP, and also has some nifty guides to help explore possibilities of when to start taking Social Security.

Bring up Open Social Security, and you’ll want to click the somewhat unobtrusive box at the top for special situations:

Then let’s fill out the form with Jill and Jack’s information – there’s a couple of things we’ll need to calculate first:

  • State Pension amount: The full State Pension is £179.60 per week, but Jack & Jill will only get 57% (20/35) of that, since they only work 20 of the 35 years required for full benefits. Assuming a $1.40 to £1 exchange rate, that comes out to $622/month each.
  • State Pension age: Check on the quick UK government calculator – for Jack and Jill, their State Pension age is 68, so they’ll start collecting State Pension in January 2053
    • There is an option to delay taking the State Pension, we’ll look at that in a bit
  • Your WEP-reduced Primary Insurance Amount. Two ways of calculating this:
    • Simple Way: If you don’t have any more Social Security earnings planned in your life, the WEP is just half of the State Pension, so $622/2 = $311. Subtract that from your non-WEP PIA – for Jill, that’s $1,103 – $311 = $792, for Jack it’s $927 – $311 = $616
    • Official Way: Use the official WEP calculator. Use your full retirement age (67 if you’re born in 1960 or later). Re-enter your earnings record, your State Pension amount from above, and it’ll spit out “Your monthly retirement benefit” – that’s your Primary Insurance Amount, reduced by WEP.

Now transcribe all that into Open Social Security:

The calculator then spits out a few different, interesting things:

  • A recommended strategy for when to start collecting Social Security, including a table showing the various amounts by year.
    • From playing around with it, this tends to be for the spouse with the lower PIA to file early, collecting their full benefit from age 62, then a WEP-reduced benefit when State Pension kicks in at 68, and for the spouse with the higher PIA to file as late as possible, collecting their WEP-reduced benefit from age 70.
    • If the difference is large enough that the higher PIA spouse has a PIA more than twice the lower PIA spouse, the lower PIA spouse will get bumped up to 50% of the higher PIA as a spousal benefit, once the higher PIA spouse starts collecting.

For Jack & Jill, we see an initial annual benefit at 62 of $7,787 from just Jack, dropping to $5,174 when he starts getting the State Pension (although Jack and Jill each start getting $7,464 from the State Pension), and finally $11,785 from Jill when she start’s getting Social Security at age 70. From age 70, that means the couple is collecting $31,887 across Social and State Pension – a good chunk of change!

  • The calculator also spits out a chart, showing how the benefits would change with alternative claiming strategies:

This is useful for seeing how big a difference it can make to claim earlier or later.

The calculator also let’s you explore some other variables. Here are two I think are particularly interesting:

What about cuts to Social Security?

As you’re likely aware, Social Security is not fully funded, and something will need to be done in the future to sustain it. That could be higher taxes, cuts to benefits, means testing, cancel the entire program and let seniors starve on the streets, etc. The actual choice is up to the politicians – without a crystal ball, I have no idea.

I think it is worth considering the possibility that benefits of current workers won’t be as high as they are today. There’s another option up top called “Possible Future Cut in Social Security benefits” – tick that box. If you scroll down to the bottom of the calculation input screen, there’s now an option to reduce the benefit by a percentage, starting in a specific year. Let’s look at Jack & Jill using the default of a 23% cut in 2034.

The calculator spits out the same kind of results, now just reduced by 23%:

Even at this reduced level, we’re still talking about more than $13k/year, plus whatever they get from the State Pension – enough to be worth considering.

How about delaying the State Pension?

This one isn’t built into the calculator, but isn’t too hard to do. There’s an option to defer taking the State Pension, which increases the benefit by about 5.8% for every year. So if Jack & Jill delay by 2 years to age 70, they’d get about $8,363 a year each instead of $7,464 (7,464*1.058*1.058). But, this bigger amount means their WEP goes up as well. Let’s recalculate that:

  • Recalculate WEP and the after-WEP PIA
    • Simple Way: Same as before, WEP is half of the State Pension. That’s $697 per month State Pension divided by 2 = $349.
      • Jill’s WEP-adjusted PIA is now $1,103 – 349 = $754
      • Jack’s WEP-adjusted PIA is now $927 – 349 = $578
    • Or re-do the official WEP calculator with the deferred State Pension amounts.
  • Update the PIA’s on Open Social Security, change the month and year in which the State Pension will begin, and submit.
  • The calculator spits out new results. For Jack & Jill, the key results don’t change too much, and the overall recommendation is the same:
    • Initial benefit on just Jack’s Social Security is the same at $7,787 – there’s no impact until State Pension kicks in.
    • Now that State Pension is delayed to age 70, the same age Jill starts collecting Social Security, there’s no intermediate stage – at age 70, Jill starts collecting $11,220 in Social Security, Jack’s drops to $4,855 due to WEP, plus they each get $8,363 in State Pension.
    • That’s now a total of $32,801 a year from age 70, compared to $31,877 if they’d taken State Pension at age 68. About $1,000 more a year, but not getting any State Pension at all for 2 years – I won’t do the present value calculations, but in Jack and Jill’s case, that doesn’t sound like a huge benefit.
      • Conceptually, this makes sense – State Pension increases at 5.8% a year, but for every extra dollar they get of State Pension, they lose 50 cents of Social Security, so you’re really looking at only 2.9% increases. That’s not very attractive, at least to me.
      • Obviously, Jack & Jill is a hypothetical, and this is not a universal outcome – try out your own numbers.

So what do I do with this information?

Three key takeaways for me:

  1. If you have 10 years of US Social Security earnings at most full-time wage levels, you’re looking at a pretty significant benefit – often something north of $1,000 a month.
    • If you don’t have 10 years of Social Security credits but you’re reasonably close, it may be worth thinking about how to get them. That might be delaying a move slightly (depending on your overall picture), using the totalization agreement, or maybe you want to do some self-employment in the UK and not elect out of paying Social Security taxes.
  2. Even if you don’t include this income in your retirement income planning, it’s worth keeping in mind for tax planning, especially when combined with State Pension.
    • Even for Jack, with the lower income history and taking Social Security early, he’s looking at $7,787 in Social Security plus $7,464 in State Pension every year. That’s something close to £11k, which doesn’t leave much tax-free space in the £12,300 Personal Allowance for withdrawals from pensions, 401(k), etc.
    • Jill would be over the Personal Allowance just with her $11,785 SS and $7,464 State Pension (about £13,750 in income).
    • Throw in some Required Minimum Distributions, and you’re very quickly well into the UK 20% basic rate, maybe pushing into the 40% higher rate income tax.
  3. The timing of when to take Social Security gets complicated, especially for a couple with a mix of Social Security and National Insurance records. There’s no one answer, but it’s worth looking into more closely when you get close to it.

How are you accounting for Social Security in your plans? I’m curious to hear your perspectives.

Tax on UK Pension Withdrawals

A relatively quick one today, on a topic I’ve been trying to nail down for a while. Disclosure up front – as always, I’m not a professional. This topic is particularly complex, and I invite discussion and disagreement; I’ll happily update this post if anybody finds any inaccuracies and call out any alternative viewpoints. Just leave a comment and we can talk 🙂

I’ll also caveat that this is a high-level, conceptual discussion. I’ve summarized about 134 pages of IRS publications in just over 1,300 words – there are many details and caveats that you’d need to research before relying on this.

The focus for today is taxation of withdrawals from your UK pension. I’m mostly considering defined contribution pensions – both workplace and a SIPP – although the same concepts generally apply for defined benefit. We’ll consider all three main withdrawal types: flexi-access drawdown, lump sum (UFPLS), and annuity.

Quick summary: the UK tax situation is clear, the US one not quite so much but still reasonable. Key takeaway is that the method of your withdrawals (periodic vs nonperiodic) has an interesting effect on how the US taxes you, something we might be able to use to our advantage (or at least need to consider in our planning). Also, it looks like it’s usually best to include pension contributions in your taxable income while you’re working.

UK Tax

The UK side is the easy part: 25% of your pension is tax-free, 75% is taxable income. You can take the 25% up front or as part of later withdrawals – for most US citizens, you won’t want that big lump sum that’s UK tax-free but probably US taxable, because you likely won’t have enough Foreign Tax Credits to fully offset the US tax, resulting in you paying real dollars to the IRS.

Today, I’m not going to discuss any further whether the US respects the tax-free status of that 25%. That’s a knotty treaty question, and not one I’m 100% convinced about. If I had to say, I find it more convincing that the US will tax all of the pension, not just 75% of it, but that’s far from a certainty.

US Tax

The US approach to tax on a UK pension depends significantly on whether you take the withdrawals as periodic payments or nonperiodic payments, so we’ll treat them separately.

Periodic Payments

This would obviously include a traditional annuity, but also if you set up a flexi-access drawdown to pay you automatically on a periodic basis – for example, if you want a pre-set monthly income. The IRS just requires that the periodic payments be paid at regular intervals (weekly, monthly, annually, etc.) for a period of time greater than 1 year.

All the details are in IRS Publication 939, and is called the “General Rule” (which is confusing, because the “Simplified Rule” seems to be actually more common for most Americans, since it applies to 401(k)s and the like, but go with it). Grab a strong cup of coffee before you dig into that one, but in a nutshell:

  • In general, the portion of each payment that can be attributed to contributions to the pension is tax-free, while the part coming from gains is taxable.
    • This assumes that the contributions were subject to income tax when they were contributed, both employer and employee contributions. If they were excluded, they don’t count as cost (makes sense – you now have to “pay” income tax on withdrawal since you didn’t “pay” when earned).
  • Because it’s a periodic series of payments, every payment includes both tax-free and taxable portions, in proportion to the overall ratio of contributions to gains.
  • Figuring the cost of the pension is mostly as simple as totaling up all the contributions – there are some subtractions for refunded premiums, unrepaid loans, and so on, but these are probably rare. The most likely would be any contributions that were previously withdrawn as a nonperiodic payment
  • Then there’s some calculations to do:
    • For an actual annuity, take a look at Pub 939, because there are specific cases for different types of annuities.
    • For periodic payments other than an annuity, you use an actuarial table to look up how many payments you expect to get. For example, if you’re 65, the IRS expects you to live another 20 years. Then, you divide the cost of the pension by the expected number of payments. For example, if you are 65 and have £120,000 of cost in the pension, you divide £120,000 by 20 to get £6,000 tax-free for each annual payment.
      • This part is a little tough to read in the pub, because it talks so much about annuities and not much about non-annuity periodic payments. If somebody else reads this section and comes to a different conclusion, I’d love to hear it!

Nonperiodic Payments

This would apply to lump sums (UFPLS) as well as nonperiodic flexi-access drawdowns. This is discussed in IRS Publication 575, which mostly covers the “Simplified Rule” that applies to qualified US plans, but also throws in this nonperiodic part.

There’s two sub-options here:

  1. If you take the payment before starting periodic payments (most likely), the payment is first allocated to gains in the pension and are fully taxable, until you’ve withdrawn all the gains. Then the payments are allocated to the cost of the pension, and are tax free.
    • Like with periodic payments, the cost of the pension is the sum of all the contributions that were included in taxable income, with some potential adjustments and caveats.
    • In practice, I think this means that all of your “early” nonperiodic payments would be fully US taxable until you’ve withdrawn all the gains, then all your “late” periodic payments would be US tax free.
  2. If you take the payment at the same time you start periodic payments or after they start (as in, you’ve got periodic flexi-access drawdown going but then you take a lump sum), the entire payment is taxable, unless the subsequent periodic payments will be reduced because of the nonperiodic payment. In that case, a portion of the payment will be non-taxable, in proportion to the reduction in future payments (there’s a slightly complex calculation involved).

So What?

Two key takeaways for me:

  • It is likely to most people’s benefit to include employer and employee pension contributions in your US taxable income while you’re working.
    • Under the US/UK tax treaty, you do have the option to exclude these contributions. Because UK income tax rates are higher than US ones, you’ll build up Foreign Tax Credits more quickly if you have less US taxable income, and potentially could use those FTCs if you start pension withdrawals within the next 10 years. That’s good, because if you don’t include these contributions, you probably won’t have any cost basis in your pension – effectively all of your withdrawals will be US taxable.
      • If nothing big changes from now, that still probably doesn’t matter much – the UK taxes on 75% of a withdrawals are still mostly more than US taxes on 100%, so FTCs wipe out any US tax owed. But that’s a pretty close calculation today, and could easily change over the years with tax updates, exchange rate movements, etc.
    • If you don’t exclude the contributions from your taxable income, you “pay” US tax in the year the contributions are made (probably, you just use FTCs and don’t actually owe anything), and build up the cost basis in your pension. In withdrawal, that means a big chunk of your pension is tax-free, and you only need to worry about US tax on the gains.
  • The differing US tax treatment of periodic vs nonperiodic withdrawals might open some interesting opportunities in retirement. For example:
    • If you’ve living off periodic payments from your UK pension in the first few years of “middle retirement” (Phase 2), the fact that only part of the withdrawal is US taxable could give you more space in the low/no tax brackets for Roth conversions
    • Since nonperiodic (lump sum) withdrawals start as taxable and then switch to tax-free once you’ve gone through all your gains, there might be an opportunity to take advantage of that switch, potentially with a substantial US and UK tax-free lump sum. There are definitely drawbacks here too, but something to think about.
    • At the very least, the two different regimes bear including in your planning, even if you wind up with a simple approach.

Any other thoughts? Ideas for how this might help or hinder you? Leave a note in the comments.

There won’t be a post next week, but I’m slowly working on wrapping up my withdrawal planning series – hopefully done by the end of June!

Tax Management in Middle Retirement (Phase 2)

This is Part 3b of our Retirement Withdrawal Strategies series.

Quick summary so far:

Today, we’ll look at “Middle Retirement” or Phase 2 in more detail. Reminder of the phases:

We’ll follow this up with Part 3c on Traditional Retirement (Phase 3), and finally Part 4 looking at a few scenarios and how it can all work in practice.

Phase 2: Middle Retirement

If you’ve made it to Phase 2, you’ve survived Phase 1, with some amount of money left (even if you’re just skidding into it by the skin of your teeth!). That’s ok, because Phase 2 is where you get access to the rest of your money:

  • Age 55: UK Pensions & SIPPs (there’s an ongoing conversation about changing this to age 57, it’s not clear yet if existing plans will be grandfathered in)
  • Age 59.5: All US retirement accounts – Traditional and Roth, 401(k), 403(b), TSP, IRA, etc.
  • Age 60: UK Lifetime ISA
  • Age 65: HSA for non-health expenses
    • This is probably in Phase 3, but conceptually fits here. I won’t go into any detail – it’s basically the same idea as a Traditional IRA unless you can use it for health expenses (even carried forward from previous years/decades!), in which case it’s more like a Roth IRA.

Three main objectives for Phase 2, carrying on from Phase 1:

  1. Ensure you have enough money to last the rest of your life without paying too much in taxes, with the boost from Social Security and/or State Pension in Phase 3.
  2. Continue setting yourself up for success in Phase 3. Three key considerations:
    • Required Minimum Distributions
    • Lifetime Allowance penalties
    • Estate planning
  3. Continue enjoying retirement!

Now that we’ve got access to all this money, with a wide variety of tax treatments, the considerations get somewhat more complicated – the “new” accounts in Phase 2 are in bold

Goal 1: Don’t Run Out of Money Before You Die

And try not to pay any more tax than you have to, along the way!

By Phase 2, you’ve likely weathered any sequence of returns risks – if you’re unlucky, your portfolio may be somewhat diminished from the beginning of Phase 1, but as long as you’ve had a sensible Safe Withdrawal Rate and maybe adjusted spending a bit, you should be ok (barring an unprecedented market collapse). If you’re more typically lucky, you’ve come out with more money than you started.

Either way, this is a good time to revisit your withdrawal plans and incorporate any updates in your plan moving forward. Maybe you’re comfortable increasing spending a bit. Maybe you’re getting a better picture of your life expectancy in light of any health issues that may or (hopefully!) may not be appearing. Maybe you want to start gifting to children or grandchildren, while they’re still young enough that it makes a big difference to their lives. And so on – it’s your call.

Once you’ve reviewed and adjusted your spending needs, if necessary, you want to start thinking about how to fill your tax-free and lower tax buckets to provide for that spending.

Starting with UK taxes:

  • Personal Allowance (£12,570 per person – all numbers are for 2021). Fill this from your tax deferred accounts:
    • US Traditional balances (IRA, 401(k), etc.)
    • UK Employer Pension/SIPP – you get to withdraw 25% tax free without counting against your Personal Allowance, so you can actually withdraw up to £16,760 if you don’t have any other wage income before you pay tax.
    • We’ll talk about which of these you want to focus on in Goal #2 – it’s all about RMDs and Lifetime Allowance – you may wind up not using much of this at all, depending on your Traditional vs Pension split.
  • Capital Gains Annual Exempt Amount (£12,300 per person). This is all from your taxable brokerage/general investment account, plus an HSA if you have one (just a taxable account to HMRC). It makes sense to fill this exemption even if you don’t need the money – capital gains harvesting, sell one investment, buy another one slightly different, and your basis increases without paying any tax.
    • Caveat: be careful of your US capital gains tax as well! You could wind up in the 15% US capital gains bracket while still under the UK annual exempt amount, especially if you have a lot of Roth conversions.
  • There are also tax-free buckets for savings interest (up to £6,000) and dividends (£2,000). These are a bit harder to manage proactively, since you’re just getting paid interest and dividends on your holdings in a taxable account, but worth considering.

And then thinking about US taxes:

  • Standard Deduction ($24,800 for married filing jointly). You can fill this from tax deferred accounts, similarly to the UK (although 100% of your UK pension will be taxable). But, you can also use Roth conversions here, which are probably not UK taxable. If you have a significant Traditional balance, you’ll probably want to focus on Roth conversions over Traditional balances, and then take out the conversions US & UK tax free after 5 years.
  • Capital Gains 0% rate ($80,000, but wage income counts against it as well as capital gains). Same idea as UK, but also need to add in any capital gains or qualified dividends in your ISA, since the US considers those as simply standard taxable accounts.
    • You can harvest capital gains in your ISA that won’t show up on your UK taxes at all, and can take advantage of the potentially larger US 0% rate. However, if you’ve got lots of Roth conversions as well, that may not leave much space.
  • The US doesn’t have a different bucket for interest and ordinary dividends, they just get taxed like wage income.

Let’s look at Goal 2 before deciding how to fill the buckets.

Goal 2: Set Up for Success

Hopefully, you’re already well on your way to managing Required Minimum Distributions, but it’s worth rechecking how you’re doing. If you’ve had more growth in your Traditional balances than you were projecting, there may be a need to readjust. Conversely, if you’ve suffered with less growth than you hoped for, there’s a small silver lining that it helps with RMDs.

You’re now also in a position to do something more active about the Lifetime Allowance for your UK Pension/SIPP, beyond just “don’t contribute so much” and “put your bond allocation here (or in a Traditional balance).” Basically, if you start to withdraw aggressively from your pension as soon as you can, you can reduce the growth of your pension and avoid going over the LTA, or at least reducing how much you go over, and thus how much attracts the 25% penalty.

There are three main drawbacks:

  1. You have to pay taxes on your pension withdrawals. Typically, 75% of the withdrawal will be UK taxable and 100% is US taxable. Very roughly, Foreign Tax Credits will usually mean the UK tax on the 75% offsets the US tax so you only owe HMRC, not the IRS. If you withdraw aggressively, it’s not hard to get into the UK 20% or even 40% brackets. Paying 40% now to escape 25% penalty and 20% income tax later is a wash at best.
  2. There are downsides to wherever you move the money you don’t spend – you can put £20k a year in an ISA, but it’ll need to be individual stocks to avoid PFIC pain, plus it’s US taxable. Your only real option is a fully taxable account, so you lose the tax deferral of the pension.
  3. Your pension isn’t part of your estate when you die, so it isn’t subject to inheritance tax. Anywhere you move that money to will be part of your estate, so could be taxed at 40% on your death. Not a big deal if you’re not expecting to leave much to your heirs, but if you’ve been fortunate and expect to have a sizable portfolio at death, it’s worth considering leaving as much of it as possible in your pension.

There’s no single clear answer on how to approach RMDs vs the LTA, but you should consider them both and come up with a plan that makes sense for you. It might be a balance of Roth conversions and pension withdrawals, might be a focus on one or the other, or you might realize that neither RMDs nor the LTA are a big deal for your particular situation – those are all valid options.

The other thing to consider here is revisiting your estate planning. Have a will up to date, start considering any gifting strategies, that kind of thing. If you’ve got a complicated situation with accounts in two countries, it’s probably worth consulting a professional, even if it’s just a one-off review, get wills and such signed, etc.

Goal 3: Continue Enjoying Retirement

You’ve now got access to all your hard-earned money, you can spend according to your plan and hopefully put most of your finances on autopilot. You’ll just need a bit of attention for withdrawals, Roth conversions, that kind of thing – hopefully something you can do with a cup of tea once a month.

Transition to Phase 3

You get to pick when you move from Phase 2 to Phase 3 – it could be anywhere as soon as 62 to as late as 70, depending when you choose to start Social Security payments. State Pension can’t be brought earlier than your State Pension age (probably between 66 and 68 for anybody reading this, may well get delayed further for some of the younger readers). The calculations can get pretty detailed – might be something I look at in a future post – but in general, the longer you wait, the more you get paid every month, but the fewer months you have remaining.

You might want to take a stab at planning out Phase 3 at the same time you revisit your plans for Phase 2, probably sometime before you get access to your pension (maybe around age 54 or 56, if you get access at 55 or 57). You’ll know your working history and can get a good idea of your Social Security and State Pension payments. We’ll talk through it in the next part, covering Traditional Retirement.

Putting it Together: Tax Management in Early Retirement (Phase 1)

This is Part 3a of our Retirement Withdrawal Strategies series.

In Part 1, we looked at when you can actually access your retirement savings, dividing retirement roughly into three phases:

In Part 2, we explored the tax-free buckets that you can use so you never pay US or UK tax again (or at least keep it very low).

Today, we’ll look at how those two elements work together, mixing and matching the accounts that you have available plus their tax implications. We’ll also look at a few of the key points for attention, to ensure long-term success. I’m going to split Part 3 into three sub-parts, one for each phase, so that you don’t have an entire book to read!

Finally, in Part 4 we’ll look at a few scenarios and examples to see how this all might work in practice.

Quick note on inflation: all figures in this series are in 2021 $ and £. I think in terms of real (after inflation) returns, and tax brackets are roughly indexed to inflation. Inflation is real, but we get to ignore it here. I also assume a constant exchange rate of $1.40 to the £ – the principles hold anywhere around that, but if we see major changes (stuff like $1 to the £ or $2 to the £), I’d want to re-check some pieces between US & UK taxes.

Phase 1: Early Retirement

Phase 1 has three main objectives:

  1. Ensure you have enough money to make it to Phase 2, when you get access to all the tax advantaged accounts
  2. Set yourself up for success in Phase 2 and especially Phase 3, when it becomes much more difficult to control your income due to Social Security, State Pension, and/or Required Minimum Distributions.
  3. Enjoy early retirement!

Your options are pretty limited here, which makes things simpler but also more constrained than later on:

Goal 1: Get to Phase 2 Without Running out of Money

In order to meet goal #1, we need to start withdrawing from our accounts, and we’d rather not pay any more tax than we have to – 0% would be nice!

On the UK tax side, it’s actually pretty easy to not pay any tax here – the only account that is taxable is your taxable brokerage account. Depending on the balance here and any gains (potentially offset by capital gains and loss harvesting), you may struggle to fill your capital gains and dividends allowances. After that, it’s all tax free, so you want to look at the US picture to decide how to make up the rest of your spending.

For the US, your taxable brokerage account remains taxable, and your S&S ISA gets treated like another taxable brokerage account. For a modest level of spending, it shouldn’t be difficult to keep capital gains and dividends below the limit, and possibly do some capital gains & losses harvesting in both accounts.

After balancing out your taxable brokerage account and S&S ISA, you may still need more money. Really the only place to get it is from your Roth contributions – you’ll want to be careful not to deplete these too fast, because they don’t go up over time and they can’t be replaced, except through Roth conversions with a 5 year wait.

Setting up those Roth conversions as soon as possible makes sense to be able to get the money before 59.5, but also because of Goal 2.

Goal 2: Set Up for Success

If you have a balance in a Traditional IRA, 401(k), or similar, you need to be planning no later than Phase 1 for how you’ll handle Required Minimum Distributions.

I go into this in detail in my How I Learned to Stop Worrying and Defuse the RMD Bomb post. Quick summary here:

  • Waiting until 72 and just accepting the RMDs will have you paying 20% or even 40% tax in Phase 3
  • Aggressively withdrawing at age 59.5 can keep overall tax to zero if you only start with about £80k ($112k). More than that, and you’re either paying 20% with your aggressive withdrawals, or paying 20% with your RMDs.
  • Roth conversions can keep tax to zero for much larger amounts, depending how early you retire. Even if it doesn’t keep tax to zero, it can probably limit it to 10 or 12% in US taxes except for very large balances
    • Very roughly, if you have more than £800k in Traditional balances at age 55, you’ll probably wind up 20%+ on some of it, but RMDs really only get out of hand and pushing you into 40%+ past £1m or so at 55.

Basically, Roth conversions need to be strongly considered if you have any Traditional balance. Start them as soon as your wage income falls below the US Standard Deduction ($12,400 single, $24,800 married filing jointly), and maybe even if it’s under the 10% or 12% brackets, depending on your overall situation.

Even better, if you are also concerned about the Lifetime Allowance and trying to plan for RMDs and the LTA at the same time, starting Roth conversions early may allow you to take some aggressive Pension/SIPP withdrawals early in Phase 2, helping to manage the LTA without pushing your income into an unfavorable US tax bracket.

Goal 3: Enjoy Early Retirement

That’s really it for the financial side – now enjoy your time! Once you have a plan for Goals 1 and 2, they should be pretty much on autopilot with some occasional attention to handle withdrawals to cash and Roth conversions.

Phase 1 Potential Pitfalls

Some quick notes on a few things that might make Phase 1 a little more challenging:

  • Some people may still have a mortgage at this point, making your spending requirements higher than they will be later in retirement. This can push you into a higher tax bracket, depending on the mortgage payments and the rest of your spending, and curtailing your ability to start Roth conversions. There’s no single right answer here, you’ll want to look at a few scenarios like accelerate repayments, paying off in full, or just planning for the increased cash requirement.
  • If you’re taking more of a CoastFIRE, BaristaFIRE, or FlamingoFIRE route and are still working in some capacity, this can quickly fill your Personal Allowance and push you into the 20% tax bracket (32% with NI contributions). Obviously means you don’t need to draw down investments (or at least not as much), but limits your ability to do Roth conversions to manage RMDs without paying extra US tax up front.
  • The sequence of returns risk is highest just after retirement, so if you get particularly unlucky and are looking at major drops in your portfolio value while also not being able to access much of your savings, things can get tight. There’s no one way of managing this, but things like flexible withdrawal rates, being open to part-time work, and, worst case, withdrawing 401(k), IRA, or LISA money with a penalty may all be options.

Transition to Phase 2

Lastly, Phase 1 ends when you start to get access to your tax-advantaged accounts (Pension, SIPP, 401(k), IRA, etc.). Depending on your age and where your savings are, there may be a substantial interim phase (age 55 to 59.5) where you have access to a UK Pension/SIPP, but none of your US accounts. Because of the way pensions are taxed (75% taxed as UK wages, probably 100% US taxable but maybe with a basis), this can be a slightly complicated period, especially if you wind up relying heavily on your pension because your Phase 1 accounts are largely depleted.

If you’re in that boat, you may want to plan this as a discrete phase with some careful planning to manage taxes as well as preparing for the transition to Phase 2, along with the longer-term planning for RMDs and LTA. In some of my scenarios, this sub-phase is actually pretty useful for LTA management, since you’re drawing substantially on your pension as soon as you can, reducing future growth, but there are drawbacks.

If you’re lucky enough to be carrying a significant balance from your Phase 1 accounts into Phase 2, it’s less critical – may still be useful for LTA management to draw down your Pension early, but the handoff from Phase 1 to Phase 2 doesn’t need to be as meticulously managed.

S&S ISA Experiment – May 2021 Update

First update on my S&S ISA Experiment – I don’t know that I’ll actually do these monthly for the long term, but at least for now I’m curious to see how it’s doing.

Quick recap of the experiment: Americans can’t hold index funds in a S&S ISA due to PFIC regulations 😦 But we can hold individual stocks! Now, I’m generally a strong believer in indexing, the Bogleheads philosophy, buy and hold, etc., but the vagaries of the US/UK tax system are forcing me into individual stocks. So, I’ve constructed a “pseudo-index” of 20 stocks, roughly replicating the FTSE 100 index of the largest UK stocks. I’m not trying to beat the market, just match it without spending a fortune in fees – my bet is really that my performance is close enough to the index that the UK tax advantages of an ISA save more money than the fees and tracking error cost, compared to investing in an actual index fund in a US taxable brokerage account.

My S&S ISA is at Hargreaves Lansdown, one of the few UK brokers that is willing to work with Americans. Their fees aren’t the lowest (£11.95 per trade adds up if you aren’t careful!), but they are manageable with some planning, and really, there aren’t any better options I’ve found. I have been pleased with their service, interface, etc. – no hesitation recommending them for people in the same situation.

To track the performance of my pseudo-index, I’m comparing my ISA against the Vanguard FTSE 100 ETF (VWRP) – that’s probably what I’d buy if I could actually buy a FTSE 100 ETF. I’m mostly interested in whether or not my selection of 20 stocks is a reasonably close approximation of the FTSE 100, but I’ll also keep track of fees along the way (I expect that will mostly just show that Americans in the UK are forced to pay higher fees than necessary, but that’s life…).

This investment makes up part of my UK equities asset allocation – it’s cheaper to buy UK-listed individual stocks (no currency exchange fees), and the the UK market is a lot smaller than the US, so I’m hoping that 20 stocks is a better representation of the FTSE 100 than it could be of the S&P 500 or something like that.

April 2021 Activity

I opened my ISA in March, but only bought 2 (AstraZeneca & Unilever) of my 20 stocks to start with – just enough to get the account open. The way the HL fees work, it’s far cheaper (£1.50 a trade instead of £11.95) if you buy stocks on a monthly plan. Fortunately, you can change the stocks and the amount every month, so as long as you have patience you can save a good chunk on fees.

April was my big startup month – I bought about £500 each of 16 more stocks, plus brought my first two up to around £500 cost basis. I’ll contribute to the last two stocks in May, fully constituting my roughly equally weighted (on a cost basis) 20 stocks. From there, I’m planning on just working my way through the 20 stocks by lowest cost basis, adding every month. I probably won’t hit the full £20k annual ISA limit, barring some unexpected good fortune.

So, as of now, I own roughly £500 each of the following: Associated British Foods, AstraZeneca, Aviva, BAE Systems, bp, Compass Group, CRH, Diageo, Experian, InterContinental Hotels, International Consolidated Airlines Group, London Stock Exchange Group, Ocado, RELX, SSE, Tesco, Unilever, and Vodafone. I’ll top that up with GSK and Reckitt Benckiser in another week or so.

There’s also about £15 in uninvested cash – with on-demand trades costing £11.95, I plan to wait until there’s at least £100 in cash before doing any trades other than the monthly £1.50 ones, and I need to keep a little cash to pay for the platform fee (0.45% a year, capped at £45, paid monthly). I have been tailoring the purchase amounts of each stock to try not to leave any more uninvested cash than necessary – for example, if a stock is £75 a share, I’ll try to buy 6 (£450) or 7 (£525) shares, not allocate £500 and leave £50 in uninvested cash, but with price movements between the day I allocate the money and the day of purchase, some cash is inevitable.

FTSE 100 vs Pseudo-Index

I’m taking a unitized approach to comparing my performance vs the FTSE 100. So whenever I buy stocks, I’m also making an Excel entry noting how much it was, the price of VWRP (the Vanguard FTSE 100 ETF), and how many units of the ETF I would have bought with that money.

For example, on 12 April I bought £8,370 of stocks, £8,293 after fees. On that day, VWRP was £78.61 a share, so I would have bought 105.49 shares (£8,293/78.61). Now, at the end of April, I see that VWRP is priced at £78.98, so those 105.49 shares are worth £8,331, as a benchmark to compare against.

Actual numbers: between March & April, I contributed £8,870 to my ISA – I actually bought £8,740 of stocks plus £15 of cash, with another £73 going to fees and £42 to stamp duty. As of the end of April, that’s worth £8,787. So I’m up £32 (0.4%) ignoring fees, down £83 with fees. If I’d bought the same £8,755 (actual invested + cash, after fees) in VWRP, I’d have £8,823, up 0.8%, or a whole £36 more than I actually have. So, definitely not the same as VWRP, but this is a short comparison period, I’m not panicking about VWRP returns being twice what I have, yet.

Graphically, two months looks very exciting – not so much, it’s dominated by my April contributions, but this should get more interesting over the months.

Observations

I’ve been spending too much time watching my account, purely out of curiosity (not doing any frequent trading!). No surprise, on any given day, the 18 stocks I own are all over the place, some up, some down. But these are all big companies – over a fairly quiet few weeks, most of them are up or down a few percent in a day, not radical swings.

We can certainly see differences in performance – the best performers are up 6-8% so far, the worst down 5%. But what I’m really curious about is whether the portfolio as a whole is a reasonably close approximation of the FTSE 100 – far too early to see that.

Here’s my summary of overall performance across the 18 stocks:

I’ve also signed up for press releases and such from all of the companies. I will say, it’s interesting to learn more about some of these giants of the UK market – some are household names, others less obvious. For example, before this experiment started I had no idea Primark was owned by a company that would sound like primarily a food manufacturer (Associated British Foods – they do also make food!).

RMDs vs Lifetime Allowance – Which Alligator Should You Focus On?

Fair warning: this post is for people who have reason to be concerned about both RMDs and the Lifetime Allowance. If you don’t have a Traditional 401k/IRA/etc. balance or you have no concerns about exceeding the LTA, you can skip on past – just focus on the one that affects you.

Also – this one gets into the weeds. Grab a cuppa first!

What are we dealing with?

Both the IRS and HMRC want to make sure they get paid eventually and ensure “rich” people don’t get too many tax advantages, they just have very different ways of doing it: the IRS has Required Minimum Distributions, while HMRC has the Lifetime Allowance.

In a nutshell:

  • RMDs force you to withdraw an increasingly large percentage of your Traditional balance (401(k), IRA, etc.) from age 72 – this can be big enough to force you above the 20% basic rate, and with a big enough balance (somewhat over £1M at age 72), even into the higher 40% rate.
  • The Lifetime Allowance means that if your total pension/SIPP value gets over about £1 million, HMRC gets extra tax, either when you take benefits or no later than age 75. This is a flat benefits tax, roughly working out to 25% (plus you or your heirs still have to pay normal income tax at some point)

These are not small differences – from a £1M portfolio at age 55, you can be looking at over a £1M difference in the value you pass on to your heirs, and a total tax burden that can be 4 times smaller than if you didn’t plan for them.

Conclusion up front: Every situation is different and there’s no one right answer. To minimize your total tax burden (and thus maximize your wealth), you want to try to do two things:

  • Get RMDs under control – ideally eliminate them entirely. As long as you’re convinced that Roth conversions aren’t UK taxable, you can avoid UK tax on your Traditional balance entirely (but might pay some 10% and 12% US tax). Even if you can’t eliminate them completely, get them down enough so that you stay in the UK 20% bracket even with the RMDs
  • If you need to worry about the LTA, try to get some money out of your pension early in retirement. This is a bit of threading the needle, trying to avoid the 25% LTA penalty but also preserving wealth out of the reach of the 40% inheritance tax.

For most people at comfortable but not “fat” levels of wealth, RMDs are probably the bigger concern, unless you happen to have almost everything in a Pension and very little, if anything, in Traditional.

For example, at a 5% growth rate, you’d need about £1.6M in pension and £600k in Traditional at age 75 before you would be paying more in the Lifetime Allowance penalty than in “forced” taxes on RMDs (about £200k each in taxes here, although you do get the RMDs to spend without any additional tax while the Pension will be subject to income tax if you take any out).

Good problems to have

Before we get into the potential pain associated with RMDs and the Lifetime Allowance, a quick reminder – both of these are very good problems to have! If you’ve retired at all early and made it to 72 with enough money in your Traditional balance to worry about RMDs, or made it to 75 with enough in your UK Pension/SIPP to worry about the Lifetime Allowance, you’ve done well. You’ve survived any sequence of returns risks and made it to the other side with a good chunk of change.

  • The taxes associated with the Lifetime Allowance only apply to pension balances over £1,073,100, and they’re marginal. If you have £1,073,101 when you turn 75, you’ll pay about a 25% penalty on that £1.
    • At a 4% Safe Withdrawal Rate, the £1,073,100 is enough for about £43k a year – after tax, that’s more like £39k a year – more than median UK household spending. Add in Social Security, State Pension, and any other savings, and you’ve got a comfortable living.
    • If you have so much more than £1,073,100 that you’re paying a material amount of tax at 75, that’s honestly a pretty good bit of gravy. We’re really talking about managing taxes for generational wealth, significant charitable giving, or a lot of luxury/leisure spending after age 75 – not making sure you can put food on the table.
  • RMDs will hit everybody with a Traditional balance when they turn 72, regardless of how big the balance is.
    • But, even if we assume that your personal allowance is already full from State Pension and Social Security, you’ll only ever get into higher rate (40%) taxes from about a £470k balance at age 75 (assuming 5% real growth). And that’s just barely getting into the bracket, once you’re into your 90s.
    • To have to pay higher rate taxes from age 72, you’d need a balance of over £960k. At that point, your RMDs alone are throwing off £37k a year and rising – even after tax, you’ve got a very comfortable retirement with RMDs plus Social Security and/or State Pension, at roughly £42k at age 72, rising to £66k at age 95 (5% growth). Add in any additional withdrawals or other savings, and you’re doing very well.

Management Options

RMDs and the Lifetime Allowance have the same three basic strategies to minimize their impact:

  1. Contribute less: keeping balances low enough can completely avoid the Lifetime Allowance problem and keep RMDs to a manageable level.
    • The obvious drawback is that you either have less money, or the money goes somewhere else, which will be less tax advantageous during the accumulation phase. For example, a Roth IRA doesn’t have RMDs, but contributions are post-tax. An ISA doesn’t have a Lifetime Allowance, but contributions are post-tax and gains are UK taxable as they arise.
    • This is really only a useful option is you’re very close to the edge on the LTA and are picking where to put some marginal money.
  2. Grow less: within your intended asset allocation, preferentially hold your bonds, and any other asset classes you think are likely to grow more slowly, in your Traditional and/or Pension accounts. The earlier you do this, the bigger the impact (reduced compound interest in your Traditional or Pension accounts), but most people don’t have a large bond allocation early in the accumulation phase. Unless you have a large bond allocation, or large amounts saved outside of Traditional and Pension accounts so that they can be mostly or entirely bonds, this is a tweak, not a solution.
    • Don’t change your asset allocation to be more bond-heavy just due to RMDs and the Lifetime Allowance – that’s the tail wagging the dog. But if you have bonds anyway, it makes sense to put them in your Traditional and/or Pension accounts.
  3. Withdraw aggressively
    • In Traditional accounts, you can start this early with Roth conversions – as soon as your earned income puts you in a low enough income bracket that it makes sense (ideally 0%, but 10% or 12% may be reasonable, too). With a long enough time horizon, this can deal with almost any plausible Traditional balance and avoid RMDs completely, or at the very least make a big dent in them.
    • In a Pension, you have to wait until age 55 (or 57, whenever you get access to your pension) before you can start withdrawing. We’ve seen that you can withdraw the entire Lifetime Allowance between age 55 and 75 while staying within the 20% basic rate tax bracket, either spending it or moving it to a different account to continue growing but without the worry of a Lifetime Allowance (probably an ISA). Of course, this doesn’t deal with any value above the Lifetime Allowance when you start, so isn’t a complete solution. It also has inheritance tax implications, since you’re potentially moving money from an account outside your estate (pension) into somewhere inside your estate and thus subject to 40% inheritance tax.

Which is worse?

This is a hard question to answer – I’ve been playing with a bunch of different scenarios, trying to make a concrete answer. The result: for the same amount of money, RMDs will likely incur more forced taxes. If, in the absence of RMDs and Lifetime Allowance concerns, you were on track to never pay taxes again, this can blow up that plan.

On the other hand, you do get those RMDs to spend – for example, if you wanted to spend £36k a year and had a Personal Allowance’s worth of State Pension/Social Security, the RMDs alone on a Traditional balance of £750k would make up the rest of the £23,250 spending in every year from age 72. The problem is that they make up way more income than you need in later years, and you have to pay tax on that – we’re talking an additional £40k/year more than you wanted, some of it taxed at 40%.

Exceeding the Lifetime Allowance causes you to pay extra tax without getting any extra money – effectively a 25%+ penalty on anything above the allowance. You still have to pay income tax if/when you or your heirs want the money, although your there’s no inheritance tax on the money in your pension.

Quick graph to illustrate – assuming a 5% growth rate, this shows both the 25% penalty on exceeding the Lifetime Allowance at age 75 and the total income taxes paid on RMDs from age 72. But remember – you’ll likely have to pay income taxes on something, whether it’s RMDs or pension withdrawals or a fat Social Security check, so this isn’t a straight comparison – the 25% penalty is in addition to income tax on whatever you’re using to fund your retirement. The only way out of paying income taxes on something are a lot of Roth conversions early on, which then become tax free on withdrawal.

For the same balance in Traditional vs Pension, you’ll always pay more income tax on RMDs than Lifetime Allowance penalty, but whether that’s a larger or smaller total tax burden depends on your overall financial picture.

So there’s no generic answer – let’s look at a few examples to try to illustrate how they could play out.

Some Examples

Bob, Polly, and Tracey are in similar situations:

  • Age 55 and have just retired, with no plans for any future earned income
  • Have £1,000,000 invested:
    • Balanced Bob has £500,000 in his UK Pension and £500,000 in his Traditional IRA
    • Pension Polly has £750,000 in her UK Pension and £250,000 in her Traditional IRA
    • Traditional Tracey has £250,000 in her UK Pension and £750,000 in her Traditional IRA
    • They have nothing in ISAs, Roth IRAs, or taxable accounts – the UK Pension and Traditional IRA will fund their retirement.
  • They all expect to take State Pension and/or Social Security at age 68, in an amount equal to the Personal Allowance (£12,570). We’ll assume a 50/50 split, so only half is US taxable (US doesn’t tax social security paid to a UK resident, per the tax treaty).
  • They will all experience steady 5% real returns in any invested balance, reflecting a moderate bond allocation in these accounts (we won’t model more bonds in one vs the other – it’s a small difference and the assumptions have a bigger impact than the strategy)
  • They’re all American citizens living in the UK. They’re each married, but their spouse has no investments or income (for the sake of simplicity in illustration)
  • They each want to spend £36,000 a year in retirement, for the rest of their lives.
  • They all expect to live to age 95
  • Tax brackets don’t change, and $1.40 buys a £
  • Their house is paid off and not considered in the examples, but it fills their entire UK inheritance tax allowance, so anything not sheltered by a pension is taxed at 40%.

We’ll look at four strategies for Bob, Polly, & Tracey:

  • Do nothing – don’t actively plan for RMDs or the Lifetime Allowance and let the chips fall where they may. They mostly split the withdrawals to fund their £36k expenses evenly between Traditional and Pension.
  • Focus on RMDs – Heavy on the Roth conversions as soon as they retire (age 55), getting Traditional balance to zero ASAP
  • Focus on Lifetime Allowance – Heavy on Pension withdrawals starting from age 55, trying to minimize LTA penalties
  • Balanced – Try to split the difference between Roth conversions & Pension withdrawals and get the overall best outcome

And a couple of big tax assumptions – these are both hugely up for debate:

  • Traditional to Roth conversions are taxed in the US but are tax-free in the UK
  • UK Pension withdrawals are 25% tax free, 75% taxed in the UK (that is certain), and 100% taxed in the US (that is debatable), but UK tax on the 75% generates enough FTC so that no US tax is owed (typically true, but there are exceptions)

These aren’t just semantic issues, either – if Roth conversions are only taxed in the US and UK pension withdrawals are only taxed in the UK, there’s a potentially huge ability to move money and avoid both RMDs and LTA penalties. But I think these are reasonable, fairly middle of the road assumptions – you have to decide for yourself, or get professional advice.

There are also some simplifying assumptions in the calculations – no interest, dividends, or capital gains, and slightly simplified US tax calculations. The outcomes should be considered illustrative, not exact.

Example Outcomes

I’ll put a vignette for each outcome at the end of this post, if you’re really interested. But for those who don’t want quite so much detail, here’s the summary, with the best outcome for each of them in bold:

PersonStrategyEnding Traditional
Balance
Ending Pension
Balance
Ending ISA + Roth
Balance
Ending Net WorthIncome Tax PaidLTA Penalty PaidTotal Tax PaidInheritance Tax (40%)Value to Heirs
After Inheritance Tax
BobDo Nothing5341,3675812,48239703974462,036
PollyDo Nothing1522,28002,432195123319612,371
TraceyDo Nothing79901,2112,01066806688041,206
BobRMD Focus02,2326882,920990992752,645
PollyRMD Focus02,68002,6809012421502,680
TraceyRMD Focus03842,3262,71016401649301,780
PollyLTA Focus002,428.2,428.19091999711,457
PollyBalanced02,68902,6898412420802,689
All values are in thousands of GBP – may not add due to rounding

There are no Bob or Tracey LTA Focus scenarios, because there’s no LTA payable even when RMDs are the focus. Bob is very close to exceeding his LTA in the RMD Focus scenario, but doesn’t quite tip over, Tracey basically can’t get to a point of worrying about LTAs from her lower starting balance, without growth well above the 5% assumption (around 8% or so she might get close to the LTA).

There’s no Bob or Tracey balanced scenarios, because there’s nothing I can find that improves on the RMD focus. There might be an option deep in the weeds to optimize on US taxes, but we’re talking about paying a little more at 10% instead of 12% – a tiny difference swamped by uncertainty and assumptions in these models.

Some observations:

  • All of these are successful retirements – Bob, Polly, and Tracey all wanted to spend £36k a year and were able to, plus pass on ample inheritances.
  • You should not ignore RMDs – even Polly benefits from managing them, despite having a relatively low Traditional balance. If Bob or Tracey ignore RMDs, they get whacked with more money than they want, paying 20%, 40%, or even 60% tax on them.
  • Focusing on the LTA while ignoring RMDs can wind up with a higher overall tax bill, even if you avoid or minimize the LTA penalty. Compare Polly’s LTA Focus to her RMD focus – her LTA penalty goes almost to zero, but her total tax paid is significantly higher due to her very high Pension withdrawals, taxed at 20%. Because her Pension has gone to zero, her estate pays a LOT in inheritance tax. After tax, her estate is more than £1M less than in her other strategies.
  • You probably won’t have a choice whether your scenario is closer to Bob, Polly, or Tracey, unless you’re still in the US contributing to a Traditional account and deciding when you want to move to the UK. I wouldn’t let retirement tax withdrawal planning drive that decision! And it’s not clear which scenario is better – for the same total balance, a higher Pension balance makes it easier to shelter from inheritance tax and RMDs easier to deal with, a higher Traditional balance helps avoid LTA penalties.
  • The apparent big advantage of a Pension in inheritance tax needs a caveat – a big ISA or Roth balance is subject to 40% inheritance tax, but not income tax when your heirs take it. A Pension doesn’t face that 40% inheritance tax, but is taxable income if your heirs take it – at whatever their marginal income tax rate is. They can choose when that is, though, whereas inheritance tax is assessed when you die.
  • The calculus changes as the total balance increases above £1M, especially if a lot of that is in a Pension. LTA becomes more and more of a concern, but there’s also less you can do about it. Big Pension withdrawals can push you into the US 22% tax bracket, so Roth conversions don’t make much sense anymore. There’s still a balance to be struck, but it becomes a lot more difficult to optimize. I haven’t done a lot of scenarios with bigger balances because it gets a lot fuzzier (and all the Excel is already making my eyes go cross!)
  • The calculus also changes a lot if Bob, Polly, and Tracey aren’t married and including their spouse on their US taxes – Roth conversions get a lot harder with only Single or Married Filing Separately US tax brackets, instead of Married Filing Jointly.

Some of the difference sin the scenarios are easier to see in graphs (balances on the left axis, annual tax on the right):

The differences in the tax curve really shows how differently these approaches behave – a simple withdrawal approach without Roth conversions has tax steady or exponentially increasing over time. A Roth conversion approach has all the tax up front, then driven to zero.

Obviously these are unrealistic scenarios with steady 5% growth – reality will be much choppier, and you won’t get that clean exponential growth in the Pension balance. Still, it shows just how small of a hiccup a even a moderate LTA penalty is (about £124k in both Polly scenarios)

Conclusions

That was a whole lot of words to say “it depends”! But really, it’s important you do pay some attention to this as part of your retirement planning and at least play out the scenarios. Some very rough guidelines that helped me arrive at the “best” scenarios:

  1. Big Pension withdrawals up front help in two ways – knock down growth in your Pension to help with the LTA and bridge your spending until US retirement accounts become available at age 59.5
    • After those first few years, dropping Pension withdrawals way down helps overall. If you do need some Pension withdrawals to support spending, it’s better to spread them out. If you have enough after Roth conversions that you never have to touch your Pension again, that’s even better (and helps with inheritance tax planning).
  2. Start Roth conversions ASAP, for another two reasons – they help knock down Traditional growth to help with RMDs and, after 5 years, they give you a pot of tax-free cash to work with. In most cases, Roth conversions to fill the US 12% tax bracket were optimal – this makes sense, because it’s avoiding 20%+ UK tax on the RMDs
    • It does make sense to continue Roth conversions all the way until you turn age 72, at least to fill the US Standard Deduction. It’s a small tweak, but saves a little tax compared to just getting Traditional to zero ASAP (moves money from 10% or 12% brackets to 0%)
    • Accepting RMDs only makes sense if you can’t get your Traditional balance to zero by age 72 without going into the 22% US bracket – then you’re balancing 22% earlier vs 20% UK tax later.

After this detour into RMDs and the LTA, I will return to the overall withdrawal strategies series. I might do a few smaller standalone posts before going into Part 3, Putting it All Together – I could use a little break from too many Excel models 🙂

Example Vignettes

Bob – Do Nothing

  • Starts with equal £500k balances in his Pension and Traditional. He can’t get to his Traditional balance until age 59.5, so starts with his Pension funding his spending, staying well within the 20% basic rate.
  • At 60, he starts splitting withdrawals 50/50 between his Pension and Traditional, still safely within the 20% basic rate.
  • When Social Security/State Pension kick in at 68, his withdrawals drop but overall income stays the same.
  • At 72, RMDs kick in. They’re big enough from the beginning to fund his retirement, when combined with SS/SP, so he never touches his pension again.
  • At 75, his remaining pension balance plus all his withdrawals to date are tested against the LTA – he comes in safely under, and pays no penalty (about £166k to spare).
  • From 76 onward, his RMDs plus SS/SP are sufficient to fund his retirement, and he takes no further withdrawals from his Pension, or anything above RMDs on his Traditional.
  • From age 76, RMDs are big enough they’ve pushed him into the 40% higher rate income tax band
  • At 95, his RMDs alone are over £66k, plus £12k from SS/SP means he has taxable income of £79k a year, despite only wanting to spend £36k
  • His pension has grown without any withdrawals since age 72, so by 95 it’s worth almost £1.4M – that can be passed to his heirs without paying inheritance tax. His traditional balance at death is about £534k, which is subject to inheritance tax. He also has £581k in savings outside his Pension & Traditional balance, probably in an ISA. That’s a total net worth of about £2.5M
  • Over the course of his retirement, Bob paid £397k in UK income tax, mostly in the 20% band with a bit into 40% in his later years, pushing his annual UK tax up to almost £20k late in life.

Polly – Do Nothing

  • Starts with £250k in her Traditional and £750k in her Pension, with Pension withdrawals to fund retirement. Comfortably in the 20% basic rate and using about £20k of LTA each year. When she can get to her Traditional balance at 59.5, she starts splitting withdrawals 50/50 between Pension and Traditional.
  • When SS/SP kick in at 68, withdrawals drop, overall income stays the same, 20% basic rate.
  • At 72, RMDs kick in. At first, they aren’t enough to keep up the 50/50 split, so she makes additional withdrawals. But as they ramp up, the RMDs alone exceed 50/50 from age 82, although she needs some Pension withdrawals to make up the rest of her spending needs.
  • At 75, her pension balance is tested against the LTA. Since she started with more than Bob but withdrew only a little bit more (withdrawals from age 72 to 75), she’s got a bigger balance – about £1.1M, and has already used about £459k of the LTA on the withdrawals., so she has £493k above the LTA. She pays 25% tax on that, totaling £123k.
  • At 95, Polly’s pension is worth about £2.3M, all of which can be passed to her heirs without inheritance tax. She has about £152k left in her Traditional
  • Over the course of her retirement, Polly paid £195k in income tax, plus the £123k LTA penalty, for a total tax bill of £319k. She was never above the 20% basic rate and paid no US tax, but the LTA penalty takes a chunk.

Tracey – Do Nothing

  • Starts with £750k in her Traditional and £250k in her Pension, initially funding spending from her Pension and then splitting 50/50 once she can access her Traditional balance.
  • At age 64, she’s fully depleted her pension, and switches to withdraw all her spending from her Traditional balance.
  • When SS/SP kick in at 68, withdrawals drop, overall income stays the same, still 20% basic rate.
  • At 72, RMDs kick in and are immediately more than her £36k spending, even ignoring SS/SP. They start at almost £49k per year, and rise to £100k at age 93. This immediately pushes her into the 40% higher rate tax bracket, and by 87 she’s creeping into the 60% bracket where the personal allowance phases out. She starts moving the excess RMDs into an ISA first, and if she uses both her and her spouse’s ISA allowance, she can just about stay under the combined £40k annual limit ( a few years in her 90s where she’s less than £2k over).
  • At 75, her pension balance is tested against the LTA, but its zero. She has more than £776k of LTA remaining anyway.
  • At 95, Polly’s Traditional balance has been significantly reduced by RMDs, but is still about £799k, down from a peak of over £1.3M in her late 70s. She has amassed a large savings in her ISA, over £1.2M, for a total net worth of about £2M, fully exposed to inheritance tax.
  • Over the course of her retirement, Tracey paid a whopping £668k in income tax, with every year from age 72 onward in the 40% bracket or higher.

Bob – RMD Focus

  • Starts with £500k each in Traditional and Pension.
  • From age 55, Bob does two things in parallel:
    • Start a Roth conversion ladder, filling up his US taxes until he’s maxed out the 12% tax bracket (over £32k of conversions every year)
    • Draw down his Pension to fund his retirement (£44k/year gives £36k after taxes on both the pension withdrawals and US tax on the Roth conversions)
  • After 5 years of Roth conversions, Bob is able to start accessing those conversions
    • So at age 60, Bob starts using tax-free withdrawals from his Roth account to fund his retirement spending
    • He ramps up his Roth conversions, completely filling his US taxes to the 12% bracket (almost £76k/year)
    • He’s not touching his Pension now, and will never touch it again, just letting it grow
    • Because all his income is coming from the Roth balance, Bob has no UK taxable income at this point.
  • By age 67, Bob has fully depleted his Traditional balance and converted it all to Roth, and is using that Roth balance to fund his retirement spending
  • From age 68, SS/SP kick in, so Bob can slow down his Roth withdrawals proportionally
  • This continues until Bob’s death at 95 – living off his Roth withdrawals and SS/SP, leaving his Pension to grow
  • At age 75 his pension is tested against the Lifetime Allowance. Because of his 5 years of withdrawals at the beginning of retirement, he knocked the balance down just enough to avoid any penalty (with about £54k to spare to the limit)
  • At 95, Bob has £2.2M in his Pension, which he can pass to his heirs tax free, and £688k in his Roth balance, which will be subject to inheritance tax.
  • Over the course of his retirement, Bob paid only £99k in income tax.

Polly – RMD Focus

  • Start with £750k in Pension and £250k in Traditional, but Polly is going to focus on RMDs, not the Lifetime Allowance
  • She can’t completely follow Bob’s approach, because she won’t be able to convert enough from her Traditional to Roth to fund her retirement – she’ll need some Pension withdrawals to make up the difference.
  • Her first 5 years are identical to Bob – pension withdrawals for income, Roth conversions to max out the 12% US bracket
  • At age 60, they start to diverge:
    • Polly starts taking some income from her Roth balance (£19k), but withdraws the remainder from her Pension
    • She keeps converting to Roth while staying within the 12% US bracket – her Traditional is depleted by age 62.
  • When SS/SP kicks in, she reduces her Pension withdrawals, but they’re still about £5k a year, along with £19k from Roth and £12k from SS/SP to make up £36k spending.
  • She continues that pattern from age 68 until her death at 95, except that around age 91 her Roth balance runs out, so she switches all of her withdrawals to her Pension.
  • At age 75, her Pension is tested against the Lifetime Allowance. With a balance of almost £1.2M plus about £386k used for previous withdrawals, she’s well over the LTA. 25% of the excess is levied as a tax, £125k.
  • At 95, Polly has £2.7M in her Pension to pass along tax free.
  • Over the course of her retirement, she paid even less income tax that Bob, just £90k, but that big LTA penalty pushes her total tax paid to £215k.

Tracey – RMD Focus

  • Start with £750k in Traditional and £250k in Pension – makes sense that she’ll focus on RMDs, since LTA will almost certainly not be a problem (it’d take some great investment returns, about 8% annually for 20 years, just to hit it)
  • She has essentially the same approach as Bob, it will just take Tracey longer to completely deplete her larger Traditional balance.
  • Her first 5 years are identical to Bob & Polly – pension withdrawals for income, Roth conversions to max out the 12% US bracket
  • At age 60, she follows Bob – shift to taking her spending from her Roth balance and increasing her Roth conversions to completely fill the 12% US bracket.
  • At age 68, SS/SP come in, being used for spending and reducing the amount of Roth conversions (although still high, almost £70k/year)
  • At age 72, she hasn’t quite depleted her Traditional balance, so starts taking some RMDs, but these are modest, starting at about £7k per year. She continues aggressive Roth conversions to fill the rest of the 12% bracket, after RMDs and SS/SP, while still drawing most income from her Roth balance.
  • At age 75, she’s finished depleting her Traditional balance and RMDs stop. From here on out, she lives off her Roth balance plus SS/SP, leaving her relatively small Pension balance to grow.
  • Her Pension is tested against the LTA at 75, but she was never in any real danger of exceeding the Lifetime Allowance, with more than £717k to spare. The 5 years of withdrawals up front just allowed her to bridge to access her Roth balance.
  • At 95, Tracey has £384k in her Pension plus £2.3M in her Roth balance. That big Roth balance is subject to UK inheritance tax at 40%.
  • Over the course of her retirement, she paid £151k in income tax, all at either the US 10 or 12% rate or the UK 20% basic rate.

Polly – LTA Focus

  • Polly is the only one who winds up paying the LTA penalty above, so let’s try to avoid or at least minimize that
  • She starts with £750k in Pension, £250k in RMDs
  • She wants to get as much money out of her Pension as fast as she can, so any compounding takes place elsewhere, probably an ISA
    • So she starts with £65k a year, paying 20% tax on a good chunk of that. She moves the proceeds into an ISA.
    • In parallel, she starts Roth conversions, up to the 12% US bracket. LTA is her focus, but we don’t want RMDs to run away with her, either, and these don’t have any UK tax impact
  • Once SS/SP starts at age 68, she scales back the Pension withdrawals a little bit, to stay in the 20% basic rate tax
    • Counterintuitively, this means she can increase her Roth conversions slightly – since 25% of Pension withdrawals are UK tax free, but 100% are US taxable, while 100% of SS/SP are UK taxable, the £12,570 of SS/SP only results in a cut of £9,600 in Pension withdrawals – that gap can be used for Roth conversions while staying in the 12% bracket
  • It all comes together at age 75 and 76:
    • She’s used the entire LTA on withdrawals and paid a small £9k penalty on her withdrawals at age 74, but those withdrawals bring her Pension balance to £0 – there’s no further penalty.
    • She finishes converting her entire Traditional balance to Roth – she had a couple of years of small RMDs starting at 72, but nothing big, although they did push her slightly into the 40% tax rate.
    • She switches from dumping money from her Pension into her ISA and from her Traditional to Roth while funding her spending from her Pension, to funding her spending from her ISA, Roth, & SS/SP.
    • From age 76, all her spending is from ISA, Roth, and SS/SP.
    • At 95, Polly has £2.4M in ISA/Roth that’s all subject to inheritance tax.
    • Over the course of her retirement, she paid £190k in income tax – much more than in RMD focus (that was £90k), because she’s just about maxing out the 20% basic rate every year until she turns 75, moving money from her Pension to her ISA and from her Traditional to Roth balance. She also paid £9k in LTA penalties, compared to £125k in RMD focus). Her total tax bill dropped from £215k in RMD focus to £199k, but now all her savings are subject to inheritance tax, instead of none of them.

Polly – Balanced

  • This is really only a very small tweak from Polly’s RMD focus – the change is just to stretch out her Roth conversions from age 55 to 72, finishing just as RMDs come in. This allows more of those conversions to be taxed at 0% or 10% US rates, instead of 12%. It’s only a modest change, reducing income tax from £90k to £84k and final net worth increasing from by about £10k, still all in a Pension.

Managing the Lifetime Allowance

We learned a little bit about the Lifetime Allowance in my post on UK Pension Withdrawal Options – mostly by pointing to the excellent Monevator post on the topic.

Today, we’ll dig a little bit deeper, to see how we might avoid paying HRMC an extra 25% of our hard earned savings. I’m going to focus on the benefit crystallisation event at age 75, where your entire pension balance is tested against the Lifetime Allowance – the principle applies to the other benefit crystallisation events too, it’s just conceptually simpler to think about a single test.

We’ll start the analysis by assuming that you haven’t touched your pension before age 75, you’ve just let it grow – maybe you’ve drawn a retirement income from other savings, Social Security, State Pension, etc. Then we can expand to look at what happens if you draw from your pension before 75, like many of us will want to.

We’ll also only look at defined contribution plans – defined benefit plans are also subject to the Lifetime Allowance, but it works a bit differently. And we’ll assume UK pensions are subject to US tax (not much changes if they aren’t – the US doesn’t care about the Lifetime Allowance, but some of the management strategies might have US tax impacts).

Bottom line up front: it’s nice to try to avoid or minimize the 25% penalty, but don’t let it overwhelm the basics of investing for growth and a comfortable retirement.

What happens if you do nothing?

If you have a pension/SIPP balance greater than the Lifetime Allowance (£1,073,100 in 2021, and frozen there until 2026 at least), the excess is subject to a penalty tax of 25%. For the test at age 75, this 25% charge would be assessed when you turn 75 – you’re still subject to income tax when you withdraw the money from the pension.

  • There’s also a 55% penalty option, which only applies if you take money in excess of the Lifetime Allowance as a lump sum. But this money isn’t subject to income tax later, so it’s basically the same as paying the 25% penalty and 40% income tax (£100 with the penalty tax at 25% leaves £75, which is then subject to 40% income tax, leaving £45 – the same as a 55% tax).
  • I’ll just call it a 25% penalty in the rest of this post for the sake of simplicity.

This 25% penalty basically limits the amount of money that the government is prepared to treat in a tax advantaged way – they want to incentivize savings for retirement, but not give too many advantages to the “rich” (we can debate if £1M in a pension saved over a lifetime of work is really “rich”, but that’s a topic best addressed over a pint).

You also can only take the 25% tax free pension commencement lump sum (PCLS) up to 25% of the lifetime allowance – so you can get £268,275 UK tax free, but not above that.

When should you care?

Simply, if you think you’ll have more than £1,073,100 in your pension – either all at one time, or if you take out some and leave enough to grow that your withdrawals plus the remainder (growth in your drawdown and the full balance in your main pot) is over the limit. The calculations get complicated, but a few examples of where you’d get to the limit – anything over these would be subject to the 25% penalty.

  • 6.5% average real growth rate, saving £2,500 a year (about 8% of the median UK salary) from age 22 to age 68
  • 5% growth rate, save and grow enough to have a £100k balance when you turn 30, and then you don’t touch it again for the next 45 years
  • 6% growth rate, save £10,000 a year in your 30s, never touch your pension again
  • 5% growth rate, saving £20,000 a year from age 45 to 65

Obviously we could make many more scenarios, but you get the idea – there are a variety of ways of getting there that require some decent contributions and discipline, but these also aren’t dramatically huge amounts of savings for many readers of this blog.

Very rough rule of thumb – if you have £750k in your pension at age 68 (State Pension age) and invested moderately (5% growth rate), you’ll likely be close to using the full the lifetime allowance at age 75.

Benefits of exceeding the lifetime allowance

Before we talk about avoiding the 25% penalty, a quick reminder of the benefits we’ve enjoyed to get to the point of caring about the penalty at all:

  • You expect to have more than £1,073,100 in your pension. At a 4% withdrawal rate, the amount under the lifetime allowance is almost £43k – after tax, that’s about £37k a year. That’s more than median household spending in the UK, and potentially a fairly comfortable retirement on its own. Add in State Pension and maybe Social Security, and you’re in pretty decent shape – the 25% penalty is hitting us on the gravy, not the foundation of a comfortable retirement.
  • You’ve benefited from tax-deferred growth for the whole time your pension has been invested. No capital gains, dividend, or interest taxes along the way to slow down your compounding.
  • Your whole pension balance is protected from inheritance tax (40%), including the amounts over the Lifetime Allowance.
  • You may have benefited from salary sacrifice when you put the money in, saving you on National Insurance (12% or 2% tax, depending on your tax rate). You never have to pay that back.
  • You may have benefited from more tax relief on your contributions than you’ll pay on your withdrawals, even with the 25% penalty. If you were in the effective 60% tax bracket (£100,000 to £125,140), you’ve saved 60% (62% with National Insurance using salary sacrifice) up front. Paying the 25% penalty plus income tax on withdrawals means that if you can keep your withdrawals and any other income under £100k a year, you’ll have an effective tax rate of 40% or 55% (25% penalty followed by 20% or 40% tax rate).

How to manage the Lifetime Allowance

There are a few options to avoid going over the Lifetime Allowance, or at least reduce the amount you go over. We’ll go into each of these in a little detail:

  • Contribute less
  • Grow less
  • Withdraw aggressively

Option: Contribute Less

This is the most straightforward option – if you don’t want to go over the Lifetime Allowance, put less money in your pension. This can have a fairly dramatic effect early on, due to compounding.

Obviously, we still want to save and grow our money, so that means you’re putting your money somewhere else. The likely options include:

  • Your spouse/partner’s pension or SIPP: probably the best option, if your spouse a) exists and b) has a lower amount in his or her pension.
    • But, you can lose out on tax relief in some cases – for example, if you’re getting 62% tax relief (salary sacrifice, with your income in the £100k to £125,140 range), but your spouse is a basic rate (20%) taxpayer and doesn’t have access to salary sacrifice (so they’re still paying 12% national insurance), you’re effectively paying an “extra” 42% on tax that you wouldn’t have to if you used your pension. Even if you then have to pay the 25% penalty, you’re losing out. Same idea applies even in less extreme parts of the tax brackets.
    • For the SIPP, we’re assuming it is actually a pension, protected by the US/UK tax treaty
  • A Roth IRA: No tax on growth or withdrawals, no Lifetime Allowance or Required Minimum Distributions to worry about, but you do give up all the tax relief on contributions – that can be very big. Also, the limit is fairly low ($6,000) and you need to be eligible.
  • A Stocks & Shares ISA: No UK tax on growth or withdrawals, no Lifetime Allowance or RMDs. But you give up tax relief on contributions and have to pay US tax on capital gains and dividends, plus have the hassle of using individual stocks. Fairly generous annual limit (£20,000 per person).
  • A Lifetime ISA: Same as with S&S, but with the added bonus of effectively 20% UK tax relief (paid as a 25% bonus), balanced with locking your money up until age 60 unless you want to pay a penalty (small – 5% plus giving back the tax relief). Very low annual limit, though (£4,000, plus another £1,000 from the 25% bonus).

Aside from potentially your spouse’s pension, depending on individual circumstances, all of those options have significant drawbacks, especially for higher income/higher tax people. You’ll have to do your own calculations to see if it’s worth it.

Oddly enough, the case is clearest for basic rate taxpayers, especially without salary sacrifice – if you happen to already be on track to meet/exceed the lifetime allowance, I don’t see a compelling argument to save 20% now just to pay 25% + income tax (probably at least 20%) later. Even with salary sacrifice, saving 32% now to pay 25% + income tax later is pretty questionable.

Once you get into the 40% higher rate bracket, and especially if you think you can keep your taxes in the 20% basic rate bracket in retirement, you’re probably better off just paying the 25% penalty later on, or at least no worse off. But that depends on a lot of factors in your individual case!

Important Caveat: It should almost go without saying, but you should never reduce your contributions to the point that you start losing out on employer contributions. That’s free money, often a 100% or more instant return. No taxes or penalties are going to beat that.

  • There’s a sub-caveat where you’re over both the annual allowance and lifetime allowance and you might actually have a tax + penalty rate of more than 100%. – you lose money by getting paid more. That’s a special situation (and a stupidly designed system) – I won’t go into it more here, things just get weird in that case.

Option: Grow Less

This is also a pretty simple option, but limited in its power. Basically, within your desired asset allocation, you choose to put assets that tend to grow more slowly in your pension – typically, this means bonds. We already want to have bonds in some kind of US & UK tax advantaged account anyway, so we don’t pay tax at income rates every year on the interest – this just means picking your pension over your IRA or 401k.

The more slowly your pension grows, the less chance of breaching the lifetime allowance, or at least you reduce the amount you go over. There’s no impact on your total growth rate – your portfolio allocation stays the same, just picking where to put bonds.

  • This is an equally applicable option to Traditional 401(k) and IRA balances to manage Required Minimum Distributions, and, unless you have a large bond allocation and/or small tax-deferred balances, you probably can’t do both. I’ll talk about the tradeoffs between Lifetime Allowance vs RMDs in my next post.

Option: Withdraw Aggressively

This last one is a bit more complicated, but it’s potentially the most powerful, especially if you’ve already got a healthy balance in your pension and the modest reduction in growth by moving your bonds there won’t really move the needle.

The basic idea:

  1. Once you turn 55 (or 57, whenever you can get access to your pension), you start withdrawing from it quickly. You can use lump sums (UFPLS) or flexi-access drawdown and then take the income from the drawdown right away, either way does the same thing – you get 25% UK tax free, 75% taxable. Possibly 100% US taxable, but the foreign tax credits from the UK tax usually wipe that out – you will want to double check for your personal situation, though, because that’s not a certainty.
  2. Every time you withdraw, that withdrawal is a Benefit Crystallisation Event, so the amount you’ve withdrawn is tested against your lifetime allowance.
  3. Because you’ve completely removed that money from the pension, it will never be tested against the Lifetime Allowance again – you can reinvest it in an ISA or wherever, without worrying about the Lifetime Allowance or it’s 25% penalty, or you can spend it.
  4. With the current (2021) lifetime allowance and tax rates, it works out that you can withdraw the entire Lifetime Allowance without paying tax above 20%, when spread across age 55 to 75.

Let’s do a quick example. The situation:

  • George is 55 and currently has £750,000 in his pension.
  • George has stopped working and doesn’t expect to have any earned income. He doesn’t have any other taxable income either (any dividends, capital gains, and interest are below the UK allowances – we’ll just ignore them).
  • At age 68, he’s eligible for State Pension and Social Security that total £12,570 a year (the Personal Allowance), so any income over that will be taxed starting at 20%
  • Because George has made his asset allocation more conservative as he approached retirement and is preferentially putting bonds in his pension, with more equities elsewhere, we’ll assume only 4% average annual real growth of his pension.
  • We’ll also assume the Lifetime Allowance is indexed to inflation, so we can just ignore inflation entirely.

Update 24Apr21: Reader John pointed out that I’d forgotten to include the 25% tax free amount, which effectively increases the withdrawal amount by a third without getting into the 40% tax rate. I’ve updated the example to reflect the tax free amounts – the concept is unchanged, but my math was wrong. Thanks John!

How does the aggressive withdrawal strategy work?

  1. Every year, George withdraws £57,000 from his pension (either UFPLS or Flexi-Access Drawdown with immediate withdrawal of the drawdown – doesn’t matter). He’ll change this to £47,400 at age 68, when he starts taking State Pension/Social Security. 25% of this is tax free, so his taxable income from the pension is £47,750 and £35,550, respectively.
  2. The taxable income (either £47,750 taxable withdrawal or £35,550 taxable withdrawal plus State Pension/Social Security) puts him near the top of the 20% basic rate bracket – George would rather not pay 40% if he can help it.
  3. Every time George withdraws that £47,4700 or £47,400, it’s tested against his Lifetime Allowance. Over the years from age 55 through 74, he uses £1,072,800 of the Lifetime Allowance (£1,073,100) – he has £300 of Lifetime Allowance left at age 75.
  4. When George turns 75, his remaining balance is tested against the Lifetime Allowance. Between 4% growth but the aggressive withdrawals, George has £21,816 in his pension when he turns 75.
  5. £21,816 is more than the £300 of remaining Lifetime Allowance, so George has to pay the 25% Lifetime Allowance penalty on the difference – 25% of £21,516 is £5,379, which comes out of his remaining balance, leaving him with £215,649 in his pension. He can use that for future income, pass it to his heirs without inheritance tax, donate to charity, etc.
  6. George also paid £193,602 in income tax on pension withdrawals along the way, for a total paid to HMRC from age 55 to 75 of £198,981.

What would have happened if George didn’t withdraw from his pension? Instead, maybe he was taking his income from an ISA, IRA, etc.

  1. George still starts with £750,000 in his pension at age 55, growing at 4% a year.
  2. He doesn’t touch it from age 55 to 75, so it grows to £1,643,342.
  3. At age 75, the balance is tested against the Lifetime Allowance. George hasn’t used any of his Lifetime Allowance, so it remains £1,073,100. £1,643,342 is more than £1,073,100, so George pays the 25% penalty on £570,242 – a tax bill of £142,560 taken out of his pension when he turns 75.
  4. That leaves George about £1.5M in his pension. It won’t be tested against the Lifetime Allowance again, and he can choose to take an income (subject to income tax but no more penalties), pass it to his heirs without inheritance tax, donate to charity, etc.
  5. George didn’t pay any income tax on his pension, but obviously needed to draw money from somewhere to fund his living from age 55 to 75, so may have paid tax on that.

At the end of the day, Withdrawal George paid a 25% penalty of £5,379, while Non-Withdrawal George paid £142,560. If Withdrawal George had been willing to pay some 40% tax on the income from his pension, he could have gotten the penalty to zero with more aggressive withdrawals early on, but obviously would have paid more in income tax. Paying 20% extra tax to avoid a 25% penalty, which will then reduce the taxable balance anyway, is basically a wash.

Personally, I think it often makes sense to fill up your 20% basic rate, but not to go into the 40% unless you actually need the income now and can’t get it from an tax free ISA or Roth IRA, or from a taxable account under the capital gains and dividends allowances. That approach also help with inheritance tax, keeping more in your pension and outside your taxable estate.

We didn’t mention US tax, because the UK foreign tax credits were enough to offset any concerns for Withdrawal George, even if his withdrawals were fully US taxable. Non-Withdrawal George hasn’t had any US income at all, so nothing to worry about.

Conclusions

To be honest, I don’t think there’s a clear right answer here – it depends on your whole financial picture. All else equal, it’s nice to avoid the 25% penalty over the Lifetime Allowance. But it’s not going to ruin you, because you’re already in pretty good shape if it’s even a concern. And a lot depends on the rest of your tax picture – trying to avoid the 25% penalty at the cost of more taxes elsewhere, or the cost of reduced growth and compounding, can really be counterproductive.

The only one that’s almost an easy win is making sure your bonds are in your Pension, or your US Traditional balance for RMD management. I can’t see any good argument for putting bonds in a Roth account, much less an ISA or taxable account.

In the next post, we add the complication of Required Minimum Distributions to the Lifetime Allowance picture. This is where it gets really fun.

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.

How I Learned to Stop Worrying and Defuse the RMD Bomb

Time for a quick pause in my bigger Withdrawal Strategies series – there’s a few detailed topics we need to get to before we can get to Part 3, combining when you get access to accounts with how to minimize your taxes and get to your money. Before Part 3 will make sense, I’m going to cover 3 more specific topics:

  • Required Minimum Distributions from Traditional IRA, 401(k), etc. and how to manage them (this post)
  • UK Pension withdrawal options and the Lifetime Allowance
  • 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.

If you haven’t read my post on Roth Conversions, start there first. This post builds on that.

Why you should care about RMDs

Required Minimum Distributions (RMDs) are withdrawals that the IRS requires you to take from your Traditional balances once you turn 72. If you don’t plan for them, they’ll wind up as UK wage income, probably taxed at 20% or even 40%+. If you do plan for them, you can get a big chunk tax free, and probably any remainder at 10% or 12%. Plus, the same strategy that helps manage RMDs can help you access your Traditional money before age 59.5, aiding your early retirement.

RMDs apply to Traditional IRA, 401(k), 403(b), TSP, etc., but critically not to Roth IRAs. They technically apply to Roth 401(k), but that be rolled over to a Roth IRA with no taxes or penalties once you leave that employer – do that when you can.

Part of the challenge with RMDs is that, at least for the first few years, they increase more slowly than typical investment growth rate assumptions (increasing around 4-5% a year), but then they keep going up, so you’re now taking a larger percentage of a larger pot. They’re fixed percentages set by the IRS – you take the same percent at age 72 whether your balance is $10,000 or $10,000,000. A few graphs to illustrate:

You can see RMDs increasing exponentially every year until they plateau at over half your Traditional balance from age 115 – if you’ve made it that far and still have a Traditional balance worth mentioning, you’ve won!

For those of us that don’t live that long, you’ve still got around a 25% chance of making it to your mid-90s, if you’ve already made it to 65. It’s how RMDs behave early on that’s part of the problem:

If you assume something like 7% growth, your Traditional balance will keep increasing (on average) until about age 100, despite your RMDs – so your RMDs keep increasing both because the % required to withdraw goes up and because your pot keeps getting bigger. By the time RMDs outstrip annual growth, you’re either dead, or your pot has had another 30ish years to grow, albeit dragged by the RMDs.

So what, you’re thinking? A bunch of theoretical percentages – let’s put some £ signs on there in an example.

Assumptions: 7% growth, Personal Allowance is filled by Social Security and/or State Pension

At your peak, you’re paying £25k+ a year in UK income taxes, and if you only need something like £36k a year to spend, you’re still getting more than £60k a year after taxes – uncontrolled income that you don’t necessarily want. Now, this isn’t the end of the world, since you’ve basically got plenty of money to spend in retirement, more than you want or need. That’s not exactly the worst problem to have. But here’s the thing – you could get exactly the same money out of your Traditional accounts, but without paying any taxes, or at least staying within the 20% bracket or lower. Let’s look at the options for managing these RMDs.

RMD Management Options

You’ve got three main options for dealing with RMDs:

Option 1: Take the RMDs

  • Take the RMDs from age 72 and pay any taxes due – this isn’t a bad option if your Traditional balance isn’t too high and your Social Security & State Pension aren’t too high.
    • In many typical cases, just Social Security and State Pension will fill up your £12,570 Personal Allowance.
      • Since RMDs, Social Security, and State Pension are all UK taxable as wages, and UK wage tax rates are higher than US ones, it’s the UK allowance we really care about – and remember, you don’t get to combine with a spouse, whatever comes out of your account counts against your Personal Allowance.
    • That pushes all your RMDs into the 20% basic rate tax bracket. If your Traditional balance at age 72 is over £500k ($700k) or so, you can get into the 40% higher rate bracket later in retirement.
    • I don’t want to pay 20% or 40% if I can avoid it – so, we need option 2.

Option 2: Withdrawals from 59.5

  • Traditional withdrawals, from age 59.5: You only have max 10 years where this really helps (age 59.5 when you can start to access the Traditional balance to age 67-70 when you start getting Social Security & State Pension), and at £12,570 a year, that’s “only” about £125k before you pay tax, and don’t forget that you’ll still be getting x% growth on the invested balance.
    • With a 7% real growth rate, you can get about an £80k ($112k) balance at age 59.5 to zero by age 68 without paying tax. Anything bigger than this, and you’ll have RMDs at 72, likely taxed at 20%.
    • You could plan to take more than the Personal Allowance to accelerate this, but you’ll pay at least 20% tax or higher at withdrawal.
    • Or, you can tackle the problem earlier and at a lower tax rate with…

Option 3: Roth Conversions

  • Roth conversions reduce your Traditional balance and manage the taxes. I recommend you start as early as possible, if you go down this route – at retirement or even semi-retirement.
    • As soon as your wage income is below the US standard deduction ($24,800 if you’re sharing with your spouse), you can convert Traditional to Roth, tax free. It’s taxed as wages, so keep your total wages (if any) + Roth conversions under the standard deduction.
    • After 5 years, you can also withdraw the Roth conversions as Roth contributions – tax free. Helpful if you’ve retired well before 59.5.
    • If you have a large Traditional balance, you may even want to convert more than the Standard Deduction – you’ll pay US tax on this, but you can keep it to 10 or 12% under $81,050 total (be careful of how this impacts your capital gains tax rate, though, if you’re also withdrawing from taxable investments or a S&S ISA). That compares favorably to UK tax on the RMDs at 20% or more, and then you get to invest the remainder tax-free forever. Very roughly, you’d want to start thinking about intentionally paying US tax at the starting values in the table below.
Retirement Age303540455055
Danger Traditional Balance at Retirement (MFJ Standard Deduction, $24,800)$330k$325k$310k$295k$270k$240k
Danger Traditional Balance at Retirement (single Standard Deduction, $12,400)$165k$160k$155k$145k$135k$120k
Danger Traditional Balance at Retirement (UK personal allowance, £12,570)£165k£160k£155k£145k£135k£120k
Assumptions: constant 7% real growth, target of zero Traditional balance at age 72. At starting balances above the values in the table, you’ll need to go above the Standard Deduction in order to get to zero. Values are rounded to be conservative, so you can start thinking, even if you don’t take action.

To illustrate this point a bit more, here’s the value of a £100 (or $100) investment growing at 7%/year in both scenarios: paying 10% tax at age 50 and never paying tax again, or paying 20% tax on withdrawal (at age 72 here):

Paying 10% tax now will always beat paying 20% later, at any growth rate. Even if you get into the 12% US tax bracket, that still beats paying 20%. If filling the 12% bracket still isn’t enough to get your RMDs to zero, you’re going to want to look at the possibility of using the 22% US bracket on Roth conversions vs the concern of RMDs getting into the 40% UK bracket. This becomes a concern around a Traditional balance of £600k at age 72, very roughly – if you’re at $750k or so age 50, you’ll struggle to get down to £600k by 72 without getting into the 12% bracket (assuming $1.4 to the £ – adjust as needed if the exchange rate drifts too far).

Big Caveat: I think Roth conversions are UK tax free, although I’m not 100% sure. Even if you think they’re UK taxable, you could convert up to the Personal Allowance (£12,570) without paying UK tax. In early retirement, unless you’re still working part time, you don’t have anything else in your wages tax bucket, so fill it with Roth conversions. Because of the lower Personal Allowance compared to a joint Standard Deduction, you can’t reduce as large of a balance – see the last row of the table above. There’s not a lot of point in exceeding the Personal Allowance – you’re picking between paying 20% now or 20% later on the RMDs, so it’s a tossup unless you think tax rates will change, or if you’re worried about getting above the 20% bracket on RMDs.

Of course, if you’re married and both partners have a Traditional balance, you can both do Roth conversions and fill each of your Personal Allowances. Be careful of exceeding the US Standard Deduction in this case; maybe you could use carried over Foreign Tax Credits to exceed it without paying tax (gets a bit complicated – I haven’t worked this one out in detail).

Comparing the Options

I’ll get into more details on some scenarios in Part 4 of the Withdrawal Strategies series, but just as a quick comparison, let’s look at four examples. All of them have a couple retiring at age 50 with £900,000 of savings, £300,000 of which is in a Traditional 401(k). They both live to age 94. There are other assumptions, but they’re pretty middle of the road and they’re all the same for each scenario – I’m just trying to show the magnitude of the difference the different strategies can make.

#RMD StrategyRMD @ 72RMD @94Total Tax Paid in Retirement
1No 401(k) withdrawals until RMDs start at age 72£31k£59k£311k
2a401(k) withdrawals up to a single Personal Allowance from age 59.5£23k£45k£213k
2b401(k) withdrawals starting at age 59.5, high enough to reach a zero balance at age 72£0£0£113k
3Roth Conversions from age 52, 401(k) withdrawals at 59.5 to reach a zero balance at age 72£0£0£28k
I’m also ignoring any Lifetime Allowance excesses in a UK Pension/SIPP – more on that in an upcoming post.

A little help from asset allocation

One more thing – you might also consider where you hold the various parts of your asset allocation, moving the bond part into your Traditional balances where possible. This has three advantages:

  1. Bonds tend to grow more slowly (but steadily) than stocks, so your future RMDs grow more slowly the more bonds you have in a Traditional account – move that growth to somewhere that doesn’t have RMDs.
  2. Bond income in a taxable account would be taxed as interest as it arises, at the higher wage tax rates, although with a healthy tax-free allowance in the UK. So you’re better off with bonds in a tax-deferred account anyway, paying the income/interest rates there, and leaving stocks in your taxable account, paying only the lower capital gains and dividends rates.
  3. Keeping bonds out of your tax-free accounts in favor of equities should allow them to grow more, without paying tax.

This applies from today, not just in retirement – if you allow your Traditional balances to grow less over the decades, you don’t need to manage them as aggressively in retirement. Based on this, I’m going to revisit my asset allocation – I won’t change the 10% target in bonds, but I may move my bonds from my Roth IRA into my TSP (similar to a 401(k), and subject to RMDs). Shouldn’t affect total returns across my portfolio, but helps reduce the size of the RMD problem.

Never Pay US or UK Taxes Again

This is Part 2 of our Retirement Withdrawal Strategies series. Part 1 is here.

Or at least, get pretty close to paying nothing – might be hard to completely escape the tax man when you have to work in two systems at once!

For a sample £900,000 portfolio at retirement, the difference between a good withdrawal strategy and a sub-optimal one could be the difference between paying less than £30,000 in taxes over 40 years, or paying more than £300,000.

Got your attention? Good – this seemingly esoteric topic can really make a difference to how much you have to spend in retirement, or however else you might want to use your money.

I need to give credit to Go Curry Cracker – his post on never paying taxes again inspired this one, but we need to extend it to include consideration of the the UK tax system. If you haven’t read his post, I encourage you to take a look and then come back here.

A quick recap of his four rules for not paying taxes:

  • Choose leisure over labor: applies to Americans in the UK just as much as anywhere else. Just like the US, the UK tax system takes much higher taxes from people with income from wages than it does from capital gains or dividends.
  • Live well for less: the less money you spend, the less you need. In the UK, you could get up to £31,870 a year per person, totally tax free. That doesn’t even include tax-free income from ISAs or Roth IRAs, and 25% tax-free from pensions. The average household in the UK spends around £31,200 – if you can live within double the average spending (as a couple), you may be able to do it without paying a penny.
  • Leverage Roth IRA Conversions: this still applies, if you have US retirement accounts (401(k), IRAs, etc.). These conversions (probably) aren’t taxed by the UK, and if you can stay below the US’s standard deduction of $24,800 (MFJ), they can be tax free in the US, too. That means you can take the money you saved (often without paying tax on it, like in a 401(k)), convert it to a Roth IRA without paying anything, and then withdraw it, still not paying anything.
  • Harvest Capital Losses and Capital Gains: applies just as much in the UK as the US. With the £12,300 UK capital gains exempt amount plus 0% US capital gains rate up to $80,800 (MFJ), there’s ample opportunity to get your capital gains for free.

Your Tax-Free Buckets

Both the US and UK tax systems have a variety of allowances, below which you don’t pay any tax at all. The short answer to minimizing your taxes in retirement is to keep your income within these buckets – anything that spills over gets taxed.

Your UK tax free buckets (if you’re married, you each get these, but you can’t share):

  • £12,570 personal allowance: covers almost everything, but especially wages (including deferred wages, like in a pension or 401(k))
  • £12,300 capital gains annual exempt amount: just capital gains (the UK doesn’t distinguish between long and short term)
  • £2,000 dividend allowance
  • £5,000 starting rate for savings: just for savings interest, you only get this if your other income is under £17,570 (it tapers from £5,000 to £0 between the personal allowance and £17,570)
  • £1,000 personal savings allowance: also just for savings interest; this drops to £500 if you enter the additional rate income tax bracket, and £0 at the higher rate level
These are best case – personal allowance and the savings buckets phase out at high enough incomes

Also worth a quick reminder of what the taxes are if you exceed those limits (this is a simplification, but close enough for us):

  • Wages & interest:
    • 20% basic rate above £12,570
    • 40% higher rate above £50,270
    • 60% effective rate between £100,000 and £125,140 as the Personal Allowance phases out
    • 45% additional rate over £150,000
  • Dividends
    • 7.5% if your overall income puts you in the basic rate
    • 32.5% higher rate
    • 38.1% additional rate
  • Capital Gains:
    • 10% if your overall income puts you in the basic rate
    • 20% higher and additional rate
    • Changes to 18% and 28% if the asset is residential property

The US has a similar system, although slightly fewer but bigger buckets. Big caveat is that most of the time, your UK taxes are higher than US, and Foreign Tax Credits will mean that you pay nothing to the US.

There are only a couple of common instances where the US taxes you on something that the UK doesn’t, and thus you may not have any FTCs to offset US taxes: ISAs and Roth Conversions (probably).

I’m using Married filing jointly numbers throughout – Single and Married filing separately are mostly half of the MFJ, with Head of Household in between. The US lets couples share 🙂

  • $24,800 Standard Deduction: covers almost everything
  • $80,000 capital gains 0% rate: covers long term capital gains and qualified dividends. This is on top of the Standard Deduction, but if your other income goes over $80,000, this pushes you in to the 15% rate

And if you go over those tax free buckets, you get taxed at:

  • Wages, Interest, Short Term Capital Gains, & Ordinary Dividends:
    • 10% up to $19,900 above the standard deduction
    • 12% from $19,901 to $81,050
    • 22% from from $81,051 to $172,750
    • And up from there, topping out at 37% above $628,301
  • Long Term Capital Gains & Ordinary Dividends
    • 15% from $80,001 to $496,600
    • 20% above $496,601
    • There’s a few exceptions at 25% and 28%, for collectibles, some small business stock, and depreciable real property – we’ll ignore those

Filling your buckets

Quick example – we’ll get into more details in future parts, but let’s see how this could work for just one year. Let’s say that Polly and Pat are 60 years old, have stopped working, and have savings across a variety of accounts: Traditional IRA (rolled over from a 401(k), Roth IRA, UK pension/SIPP, S&S ISA, and a taxable brokerage account. And they’d like to spend £48,000 this year – that’s 1.5x the national average, and probably a pretty comfortable retirement.

Let’s fill up their buckets and see how they can avoid paying any tax, plus planning for the future. Remember that UK taxes are always filed separately – they don’t get to share allowances as a couple (very small exception for the marriage allowance – we’ll ignore that for now).

  • Polly’s buckets:
    • £5,000 personal allowance: she fills this from her tax deferred accounts – Traditional IRA, Traditional 401(k), UK Employer Pension, and/or SIPP. If you use the Employer Pension or SIPP, you can actually take £16,750 before paying tax, because 25% of the withdrawal is tax free. We could use more, but we want to keep our US taxable income low, we’ll see why. In a future part, we’ll see why she probably wants to use her US Traditional accounts first (hint: RMDs).
    • £5,000 capital gains annual exempt amount: from your taxable brokerage account (US or UK). We could use up to £12,300, but Polly doesn’t have enough gains in her account to do that. Because this is just on the gain, let’s say Polly actually gets £15,000 to spend, but she only includes the gains on her taxes.
    • £1,000 dividends allowance: also from her taxable brokerage account. Again, Polly’s account isn’t big enough to use the full £2,000.
    • £3,000 from tax free accounts: S&S ISA, Roth IRA, and 25% of your UK pension/SIPP. We use this to make up the balance – it’s the last place to go after filling up your buckets as best you can.
    • With the starting rate for savings or the personal savings allowance, whatever Polly has in taxable savings accounts is likely tax free (at a 1% interest rate, Polly could have up to £600,000 in cash before paying tax – you probably don’t want this much cash!)
    • All total, that’s £24,000 from Polly without paying a cent
  • Pat does exactly the same – maybe Pat has a slightly different mix of accounts or balances in each, but the same principles apply.
    • This does get more difficult if one spouse has much higher balances than the other, for example if one had a long working career and the other did a mix of full time working, unpaid work at home with young kids, part time work, etc.
  • Together, Polly & Pat have £48,000 to spend, with no UK tax due.

Let’s take a quick look at this from the US side (I’m assuming a pound buys $1.40):

  • Standard deduction: $14,000 from tax deferred accounts is less than $24,800 – no tax here
    • Looking to the future, Polly & Pat use the remaining $10,800 for a Roth conversion – they pay no taxes now, because they’re under the standard deduction, and when they want the money at least 5 years in the future, it’s tax-free.
  • Capital Gains: £10,000 capital gains + £2,000 dividends + maybe £2,000 of the tax free accounts is capital gain on a S&S ISA, which is US taxable. Total of $19,600 – way under the $80,000 0% capital gains rate
    • Again looking to the future, Polly & Pat harvest some more of their capital gains – £7,300 each, until they hit the UK limit. That’s an additional $20,440 here, still well below the point at which they pay any US or UK tax. And now that they’ve realized those gains, they don’t have to pay tax on them again. In practice, they probably sell one stock/fund and buy a slightly different one – that money is still invested and growing, but starts the capital gain calculations over from zero.

Conclusion & Next Steps

By managing our retirement income based on the tax-free buckets provided by both the US and UK and living slightly modestly (at about the 80th percentile of household spending – not THAT modest!), we can avoid paying any tax this year, and set ourselves up to continue paying no (or very low) taxes for the rest of our lives.

In Part 3, I’ll put together the approach to not paying taxes with the phases of retirement – each phase needs a different approach, and has a few unique pitfalls to avoid.

In Part 4, I’ll wrap it all together with some scenarios and examples of how an entire retirement’s worth of withdrawals can look, and how following a sensible plan could save hundreds of thousands in tax for a typical retirement.