UK residents – be careful!
If you’re a UK resident, take caution. Although the special distribution may be tax free in the US, they may not necessarily be so in the UK. The US-UK tax treaty states that any pension payment not taxable in the US will also not be taxable in the UK. This is welcome news, but there could be a timing problem as the amounts will only not be taxable if repaid within the 3 year window. Let’s look at an example below.
Ms Garlic, a US citizen living in the UK, is a self-employed dog groomer, who was unable to work due to the COVID-19 restrictions. She withdraws $90,000 from her IRA on May 5, 2020, intends to repay the amount to her IRA within 3 years (by May 5, 2023) and meets the IRS criteria for the COVID-19 distribution relief.
The payment falls within the 2020/21 UK tax year and the return and tax payment for this year is due on January 31, 2022. This means that provided the $90,000 is repaid to the IRA prior to this date, none of the distribution will be subject to UK tax. This is over 15 months earlier than required under US law. Assuming this is Ms Garlic’s only income, any amounts subject to UK tax will be taxed at 20%-40% rates.
If the withdrawal had been made prior to April 5, 2020, this also falls into the 2020 US tax year, but would fall into the 2019/20 UK tax year with tax due on January 31, 2021. If the UK return is filed and tax paid before the IRA “loan repayment”, the return can be amended and a refund of UK tax claimed. However, if the amount is not repaid you should ensure the foreign tax credit position lines up correctly in both countries.
For example, if on January 31, 2022 Ms Garlic still has not repaid $30,000 of the loan, this will be taxable on her 2020/21 UK tax return at 20%. Assuming this tax was paid in 2022, this could lead to a mismatch of foreign tax credits as the pension would be taxable in 2020 for US tax purposes (or 2020, 2021 and 2022 if spread over 3 years).