U.S. Retirement Savings Plans: 401(k), IRA, and Tax Considerations for US and the UK expats

Tax-Free Accounts (like Roth IRA and Roth 401(k))

Ideal for index funds, ETFs, and individual stocks.

• Withdrawals after age 59 1/2 are tax-free in the US and UK.

Roth IRA

• Contributions are limited and subject to income restrictions.

• Required minimum distributions (RMDs) are not required at any age.

Roth 401(k)

• No income limits but restricted to US company employees.

• RMDs are no longer required.

• Roth IRAs and designated Roth accounts in 401(k)s and 403(b) do not have the required minimum distribution (RMD) while the account owner is alive. However, RMD rules do apply to beneficiaries of these accounts.

IRA Early Withdrawal Penalties and the 5-Year Rule

• A 10% penalty applies to withdrawals of growth before age 59½, unless there's an exception (contributions can be withdrawn without penalty).

• The 5-year rule requires you to wait at least five years after your first contribution to withdraw earnings without incurring penalties or taxes.

Failing to comply with the 5-year rule will lead to taxes and penalties.

Roth Options and UK Tax Implications

A Roth option (both in a 401(k) and an IRA) is often preferable to a traditional 401(k) or IRA for US citizens in the UK.

• If you are paying UK taxes on wages, salaries, or self-employment, these taxes might already cover the US taxes you'd normally owe on contributions to a Roth IRA or Roth 401(k) (which are made with after-tax dollars).

• This offers potential savings when you withdraw your retirement funds in the future.

Foreign Tax Credit

• The US-UK tax treaty allows you to claim a foreign tax credit on your US tax return for income taxes paid to the UK.

Offsetting US Tax Liability

• If your UK tax rate is higher than your US tax rate, the UK taxes you pay on your earnings could be enough to offset any US tax liability on your Roth contributions.

• This allows you to contribute to a Roth account with "pre-tax" money, similar to a traditional account, while still enjoying the benefits of tax-free growth and withdrawals in retirement.

• Example:

  Let's say you're a US citizen in the UK earning £60,000 and contributing to a workplace pension. You're paying a significant amount of UK income tax on those earnings. When you file your US tax return, you can claim a foreign tax credit for those UK taxes paid. This credit could eliminate your US tax liability, including any taxes you would have owed on Roth contributions.

Potential Issue with Roth accounts:

While Roth IRA distributions are generally tax-free in the United States and the United Kingdom, many countries do not recognize this tax-advantaged status, treating them similarly to traditional retirement accounts. This means you could face taxation on withdrawals in your next country of residence, even if they are tax-free in the U.S. and U.K.

Tax-Deferred Accounts (Traditional IRA/401(k))

Suitable for the same assets as Roth accounts.

• Contributions may be tax-deductible, and taxes are deferred until withdrawal.

• However, traditional IRA/401(k) contributions may offer limited benefits for Americans working in the UK due to the potential lack of US tax deductions caused by the higher UK tax rates.

• RMDs generally begin at age 73.

• However, if you're still working and own less than 5% of the company you work for, you can postpone RMDs from your current employer's retirement plan until you retire.

• You must still take RMDs from other retirement accounts, including those from previous employers.

US Taxable Accounts

• Best for assets that don't benefit from tax-advantaged accounts.

• These assets include:

• Foreign High-Dividend Stocks: The dividend is taxable in the foreign country, and you can’t claim it in a tax-favored account.

• Treasury Bonds: Due to state income tax exemption and lower expected returns.

• When to Prefer Taxable Accounts:

• Early Access to Funds: Needed before retirement age (59 1/2 for the US or pension age for the UK).

• Exceeding Contribution Limits: When tax-advantaged accounts are maxed out.

• No Tax Deduction on 401(k): If working in the UK without US tax deductions on contributions.

• Leaving Assets to Heirs: Beneficiaries receive a step-up in basis and no withdrawal restrictions.

Converting a Traditional IRA to a Roth

• If you're a high-income earner, you may be ineligible to contribute directly to a Roth IRA.

• However, a clever strategy, informally called the "Backdoor Roth", can help you get around this limitation.

• It works by first making a non-deductible contribution to a Traditional IRA.

• You can then convert those funds to a Roth IRA in the year of the conversion.

• Since your initial contribution was non-deductible (meaning you already paid taxes on it), you'll only owe taxes on any earnings accrued in the Traditional IRA.

• Overall, this strategy is a powerful tool to help high-income earners build wealth for retirement. However, you must follow all the rules outlined by the IRS, including the "pro-rata rule," which applies if you have existing pre-tax balances in any traditional IRAs. This rule dictates that a portion of the conversion will be taxable, even if you only convert non-deductible contributions.

Treaty Benefits

• Retirement plans like 401(k)s and IRAs are recognized as tax-advantaged in both the US and the UK.

• This means that these accounts enjoy tax-free growth, and once you reach the age of 59 1/2, distributions from traditional 401(k)s and IRA(s) are taxable by the country of residence.

• If you are a resident in the UK at that time, you may be able to claim the taxes paid to the HMRC on your US federal tax return, avoiding being taxed again on the same income.

• Distributions from a qualified Roth IRA and Roth 401(k) become tax-free in the US and the UK.

• To be considered qualified, the distributions must meet the requirements for tax-free treatment in the US (e.g., the account holder must be over 59 1/2 and the account must have been open for at least five years).