By the time this issue of American in Britain has been published, new Chancellor Rishi Sunak will have delivered the first budget since October 2018. At the time of writing major news outlets, including The Times and The Financial Times, have predicted that reforms to pensions will feature prominently in the budget, with the potential for cuts to tax relief on pension contributions.
Whether or not these changes are introduced, the attention being afforded to pensions should serve as a prompt to consider one’s personal position as we end one UK tax year and begin another. Pension planning is particularly important for Americans in the UK as pensions are one of the few ways Americans expats can access the markets in a relatively straightforward, and most importantly, tax efficient, manner.
UK Pensions
There are a number of different types of pensions in the UK, however, it is predicted that defined contribution pensions, the most common type of pension, are likely to be targeted by the Treasury (and if not now, at some point in the future).
Defined contribution pensions are somewhat similar to US 401(k) plans in that contributions made by the employee and/or the employer are invested in a variety of assets by the pension provider, with any subsequent income or capital growth being tax deferred. In addition to serving as a tax efficient ‘wrapper’, defined contribution pensions also generally provide for income tax relief when contributions are made.
As the law stands pre-budget, contributions to defined contribution pension schemes - as well as some other types of UK pension schemes - receive income tax relief in one of two ways:
1. Net pay arrangement
Under the net pay arrangement, pension contributions are made from an employee’s gross pay, before the deduction of tax. This results in an employee receiving tax relief automatically through payroll.
2. Relief at source
Conversely, relief at source refers to a pension where the employee’s pension contributions are made after the deduction of tax. In such pensions, the pension scheme provider claims tax back from the government at the basic rate of 20%. This amount is then added to the employee’s pension.
For basic rate taxpayers no further action needs to be taken to receive full income tax relief. However, in order for higher and additional rate taxpayers enrolled in relief at source arrangements to receive full income tax relief, UK self-assessment tax returns need to be completed. This is because pension contributions made under the relief at source scheme also increase the basic rate and additional rate tax bands (currently at £50,000 and £150,000, respectively) by the amount of gross pension contribution made.
Rumoured Changes
Reports in the media had suggested that Rishi Sunak’s predecessor, Sajid Javid, was considering cutting pension tax relief for higher earners. Although relatively little is known about Rishi Sunak’s plans for the budget, cutting pension tax relief would help the Chancellor avoid reneging on the government’s pledge to keep income tax, National Insurance and VAT rates static.
Whilst it is uncertain how a cut to pension tax relief would operate in practice, it is thought that individuals in a net pay scheme would not lose the 20% payment from the government, but equally, would not see their rate bands increased. It is unclear how cuts would affect those with net pay arrangements.
Reasons To Maximise
Pension Contributions Even if the Chancellor proceeds in cutting the rate of pension tax relief for higher earners, making pension contributions is still beneficial for most Americans in the UK. As they serve as a tax wrapper, Americans in the UK can choose from a wider variety of tax efficient funds to hold in their pensions as the IRS’s Passive Foreign Investment Corporation (PFIC) rules and as HMRC’s reporting fund regime generally do not impact investments within a pension. Because of this, UK pensions can serve as vehicles for Americans wishing to access certain investments that they may not wish to hold directly in their personal name due to tax inefficiencies.
A further tax benefit of UK pensions is that in certain circumstances, Americans may be able to utilise excess foreign tax credits to set against pension contributions made whilst living abroad. This has the benefit of creating a base cost within the pension from a US tax perspective. Should that taxpayer return to the US or move to a jurisdiction with a lower tax rate than the US, an uplifted base cost would reduce any US tax due. Anyone wishing to explore this planning opportunity should speak to their tax adviser.
IRA Contributions
Even if there is a raid on UK pensions, the extent to which tax relief is restricted is unlikely to be enough to discourage contributing to a UK pension altogether. It is, however, important to be cognisant of other options, should further cuts to UK pensions be mooted in the future. Two such options Americans in the UK may wish to consider are Traditional and Roth Individual Retirement Accounts (IRAs). As their name suggests, IRAs are long-term defined contribution savings accounts designed to help US taxpayers save for retirement.
Although contributions to IRAs by Americans in the UK will not necessarily attract the same income tax benefits as contributions to UK pensions, these accounts can nonetheless serve as useful planning tools and provide a tax wrapper of sorts to hold less tax efficient investment options.
There are limits to the amount one can contribute to an IRA and the ability to make contributions generally does depend on an individual having earned income that is not offset by the foreign earned income exclusion. In 2020, the total contributions an individual can make across their Traditional and Roth IRAs is limited to $6,000 ($7,000 for those age 50 or older). Additionally, like UK pensions, the amount an individual can contribute directly to a Roth IRA is tapered according to their level of income and also depends on their tax return filing status in the US.
Traditional vs Roth IRA
Both Traditional and Roth IRAs are treated as qualified pensions and therefore all investment growth is tax deferred or tax-free, respectively, in both the US and the UK. Additionally, like a UK pension, the underlying investments in an IRA are sheltered from the negative impact of the PFIC rules or HMRC’s reporting fund regime.The main differences between a Traditional and a Roth IRA are that Traditional IRA contributions can in certain cases be made from pre-tax or post-tax dollars whilst Roth IRA contributions can only be funded with post-tax dollars. Additionally, distributions from Traditional IRAs are taxed at one’s marginal tax rate whilst withdrawals from Roth IRAs are tax- free in both the US and the UK.
In the case of Traditional IRAs, required minimum distributions (RMDs) are obligatory once the holder reaches the age of 72. Recent US pension legislation enacted at the start of 2020 increased the age one must take RMDs from 70.5. Additionally, before this legislation was enacted, Traditional IRA holders who had been required to make RMDs could not contribute to a Traditional IRA. From January 2020, holders who have qualifying earned income can continue to make an annual, Traditional IRA contribution.
Conversely, Roth IRAs do not necessitate RMDs and, as with Traditional IRAs, withdrawals can generally be made freely from the age of 59.5.
When To Invest
Although the topic and content of this article has been spurred by the budget and the tax year-end, the end of the financial year does not need to dictate the point at which one gets their finances in order. Many of these planning opportunities can be implemented at the start of the year to maximise investment return.
For example, since 2016, those earning over £150,000 have had the amount they can contribute into a UK pension restricted, with those earning over £210,000 seeing their contribution limit tapered to £10,000.
In some cases, such as bonuses, these high earners may not be able to determine the exact amount they can contribute into their pensions until the end of the tax year.
Despite this uncertainty, an individual could choose to invest £10,000 as early as possible in each tax year and top up as necessary when their earnings are confirmed. Due to the compounding effect, were a taxpayer to contribute £10,000 each year at the beginning of the tax year for 10 years in a portfolio averaging a theoretical 7% gross return, they could be more than £21,000 better off than if they were to invest at the end of the tax year, as they would have had a longer period in the market.
The return figures above are purely illustrative and the portfolio performance are not guaranteed and depend on the investments. Additionally, these figures do not take into consideration any charges or taxes that could be due and would reduce the value of the overall pension and the performance.
Summary
Despite the changes expected, many planning opportunities still exist for Americans in the UK, especially surrounding UK pensions. Due to the tax deferred nature of a UK pension and the income tax relief available on contributions, it is recommended that contributions continue to be made, regardless of any changes made during the budget.
In conjunction with making contributions to a UK pension, Americans should also consider investing in an IRA as these accounts have different rules for withdrawals and, in the case of a Roth IRA, can provide for tax-free growth and distribution.
Additionally, it is recommended that contributions are made as early as possible in the tax year to take advantage of the compounding effect. Whether approaching retirement age or simply planning for the future, the investment strategy of your pensions, the amount needed to provide for retirement and a systematic drawdown strategy should become a point of discussion with your Wealth Adviser.
Risk Warnings And Important Information
MASECO LLP (trading as MASECO Private Wealth and MASECO Institutional) is registered in England and Wales as a Limited Liability Partnership (Companies House No. OC337650) and has its registered office at Burleigh House, 357 Strand, London WC2R 0HS.
MASECO LLP is authorised and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is an SEC Registered Investment Advisor in the United States of America.
This article does not take into account the specific goals or requirements of individuals and is not intended to be, nor should be construed as, investment or tax advice. Information contained in this article is based on MASECO’s understanding of current regulations and tax law and legislation which is subject to change. MASECO Private Wealth is not a tax specialist and does not provide either tax or legal advice. The tax treatment of any investment strategy or investment in a financial instrument depends on the individual circumstances of each person and may be subject to change in the future.
You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy. We strongly recommend that every person seeks their own tax advice prior to acting on any of the tax opportunities described in this article.
Stephen Johnson is a Senior Wealth Executive at MASECO Private Wealth. Stephen graduated from Skidmore College with a degree in English before moving to the UK to complete his GDL at City Law School and his LLM from University College London. Prior to joining MASECO Steve worked for a number of years as a private client tax adviser.
Email: Stephen.Johnson@Masecopw.com or call on: 0207 043 0455
