Missed US Tax Returns and UK Annuity Income

Missed US tax returns are the usual starting point when a US citizen or green-card holder living in the UK has been receiving annuity income for years and has only ever dealt with HMRC. The short answer is that the annuity is reportable in the United States every year, that each payment is split under US rules into a tax-free return of your own money and a taxable balance, and that the UK tax already deducted normally offsets most or all of the US tax through the foreign tax credit. The returns still have to be filed, and the split has to be worked out under US law rather than copied from the UK certificate.

This guide covers the two kinds of annuity we see most in UK-resident American households: a purchased life annuity bought with your own capital, and a lifetime annuity bought with UK pension savings. Drawdown and final salary schemes behave differently and are covered separately.

Missed US tax returns and a UK annuity: what is the actual problem?

The problem is rarely unpaid tax on a dramatic scale. It is that a regular, documented, UK-taxed income stream has never appeared on a Form 1040, and that the contract behind it may never have appeared on the asset reporting forms either. The provider deducts UK tax, so the recipient assumes the income is fully dealt with. The United States taxes its citizens and lawful permanent residents on worldwide income wherever they live, so the same payments belong on a US return as well.

How does the UK tax a purchased life annuity?

A purchased life annuity is an annuity bought with your own capital rather than with pension savings. For UK income tax it benefits from a partial exemption: each payment is treated as containing an exempt capital amount, which is not taxed, and an income balance, which is. HMRC's Insurance Policyholder Taxation Manual at https://www.gov.uk/hmrc-internal-manuals/insurance-policyholder-taxation-manual/iptm4300 sets out the framework. The charge sits in Part 4, Chapter 7 of the Income Tax (Trading and Other Income) Act 2005 and the partial exemption in Part 6, Chapter 7 of the same Act.

The manual makes three points that matter for a cross-border file. First, the legislation prescribes the amount of each payment that is treated as exempt, and the exemption operates once a claim has been made, so the capital amount is a statutory figure and not something the annuitant or provider chooses. Second, tax is charged on the person receiving or entitled to the payments, on the payments arising in the tax year. Third, that person is given credit for any tax deducted by the payer, and no tax is charged on the exempt capital amount. In practice the provider's annual certificate shows the gross payment, the capital amount, the taxable amount and the tax deducted. Those four figures are the raw material for the US return.

How does the UK tax an annuity bought with pension savings?

A lifetime annuity bought with UK pension savings is treated quite differently. There is no capital element. The payments are pension income and are taxable in full, subject to the Personal Allowance and the normal income tax bands. GOV.UK confirms at https://www.gov.uk/tax-on-pension that you pay tax if your total annual income is more than your Personal Allowance and that a private pension, whether workplace or personal, counts towards that total, although some of it can be taken tax-free. That tax-free element is a lump sum taken at the outset, not a slice of each annuity payment.

The provider generally operates the tax through its payroll, so the annuitant receives a net amount and a year-end statement of gross income and tax deducted. A wealthy annuitant with other income frequently has an additional UK liability through Self Assessment on top of that. For US purposes, the point to hold on to is that the UK treats 100% of each payment as income, while the US may or may not, depending on whether you have any investment in the contract under US rules.

How does the US tax annuity payments under section 72?

The US rule is the exclusion ratio. Section 72 of the Internal Revenue Code, which can be read at https://www.law.cornell.edu/uscode/text/26/72, starts from the position that gross income includes any amount received as an annuity, and then excludes the part of each payment that bears the same ratio to the payment as the investment in the contract bears to the expected return, both measured at the annuity starting date. The annuity starting date is defined as the first day of the first period for which an amount is received as an annuity under the contract.

The IRS publishes the mechanics in Publication 939, General Rule for Pensions and Annuities, at https://www.irs.gov/publications/p939. The General Rule is the method that applies to payments from a nonqualified plan, which the publication illustrates with a private annuity, a purchased commercial annuity or a nonqualified employee plan. A UK annuity is not paid from a US qualified plan, so in the returns we prepare the General Rule is the working method. Publication 939 lays the computation out in six steps:

• Determine your investment in the contract.
• Determine your expected return, using the IRS actuarial tables in the publication for a life annuity.
• Divide the investment by the expected return and round to three decimal places. This is the exclusion percentage.
• Multiply the exclusion percentage by the first regular payment to find the tax-free amount of each payment.
• Multiply that tax-free amount by the number of payments received in the year.
• Subtract the tax-free total from the payments received. The remainder is the taxable amount.

There is also a ceiling. Section 72(b)(2) limits the exclusion to the unrecovered investment in the contract, and Publication 939 describes the net cost as the maximum amount you may recover tax free under the contract. Once the whole investment has been recovered, every later payment is fully taxable for US purposes. An annuitant who has been in payment for a long time therefore needs the computation run from the starting date, not from the first year being filed, because the amount already recovered in earlier years determines how much exclusion is left.

What is the investment in the contract for a UK annuity?

The investment in the contract is, under section 72(c)(1), the aggregate of premiums or other consideration paid for the contract, less amounts received before the annuity starting date that were excludable from gross income. For a purchased life annuity bought with after-tax capital this is usually straightforward: it is the purchase price, evidenced by the provider's schedule and the bank debit, translated into dollars. The translation point is the one that needs care, because the purchase happened on a specific date and the payments arrive over many later years at different rates. The file should record which rate was used for the purchase price and why.

For an annuity bought with UK pension savings the answer is much less obvious and depends on the history of the money. IRS Topic 410 at https://www.irs.gov/taxtopics/tc410 describes the investment in the contract as the after-tax amount you paid, including employer contributions that were taxable to you when contributed, and says payments are fully taxable if you made no after-tax contributions. Section 72(f) applies the same idea to employer contributions: they count only to the extent they were includible in the employee's gross income, or would not have been includible had they been paid directly to the employee at the time.

Publication 939 also carries a specific rule for people who were nonresident aliens when contributions were made. Contributions are left out of cost if they were based on compensation for services performed outside the United States while the individual was a nonresident alien and were not subject to income tax under the laws of the United States or any foreign country. A green-card holder who built up a UK pension with UK tax relief before becoming a US person should therefore not assume that the whole fund counts as US cost. A US citizen who contributed while filing US returns, and whose contributions or employer contributions were taxed in the US at the time, may have real cost to recover. Where returns were never filed, establishing what was and was not included in US income is a judgement on the facts, and we document the position taken rather than present it as settled.

Where does a UK annuity go on Form 1040 without a Form 1099-R?

A UK provider does not issue a Form 1099-R, and its absence does not change the reporting obligation. The gross annuity received in the year and the taxable amount are entered on the pensions and annuities lines of Form 1040, with the taxable figure produced by the General Rule worksheet and kept in the file. Because there is no US information slip, there is also no US withholding to claim. The UK tax deducted is not withholding for US purposes. It enters the return, if at all, as a foreign tax credit.

Annuity income is not earned income, so the foreign earned income exclusion does not shelter it. Once the income is an annuity, the foreign tax credit does the work.

Does the US-UK tax treaty stop the US taxing a UK annuity?

For a US citizen, generally not. As we read the 2001 US-UK income tax convention, Article 17 provides that an annuity beneficially owned by an individual resident in one country is taxable only in that country, and it defines an annuity as a stated sum paid periodically at stated times during life, or during a specified or ascertainable period, under an obligation to make the payments in return for adequate and full consideration other than services rendered. On its face that would give the UK sole taxing rights over a UK resident's annuity.

The convention also contains a saving clause in Article 1 that allows the United States to tax its citizens and residents as if the convention had not come into effect, subject to a list of exceptions. On our reading the annuity paragraph of Article 17 is not among those exceptions, although relief from double taxation under Article 24 is. The practical result is that a US citizen in the UK reports the annuity on the US return and relieves double taxation by credit, not by exemption. A green-card holder who is UK resident may have a different analysis under the treaty residence rules, with consequences of its own, and that should be worked through on the individual facts. Anyone relying on a treaty position should read the article text itself.

How does the foreign tax credit work when the UK and US splits differ?

The foreign tax credit lets UK income tax paid on the annuity offset the US tax on the same income, within a limit based on the US tax attributable to that foreign income. Where the two countries taxed identical amounts, this would be simple. With annuities they rarely do, and the mismatch runs in both directions.

• Purchased life annuity, UK capital amount larger than the US exclusion: the UK taxes less than the US does, so UK tax may not fully cover the US liability and some US tax can remain payable.
• Purchased life annuity, US exclusion larger than the UK capital amount: the UK taxes more than the US does, leaving unused foreign tax that may be carried to other years within the US rules.
• Purchased life annuity after the US investment is fully recovered: the US taxes the whole payment while the UK computation continues to follow its own statutory rules.
• Pension annuity with no US investment in the contract: both countries tax the full payment, and for a higher-rate UK taxpayer the UK tax usually exceeds the US tax on that income.
• Pension annuity with some US investment in the contract: the US taxes less than the UK does, again producing surplus UK tax.

Timing adds a second layer. The UK tax year runs to 5 April and the US year to 31 December, so the provider's certificate does not line up with the US return. We rebuild the payments month by month onto a calendar-year basis and allocate UK tax consistently with the method chosen for the credit. The method must be the same across all catch-up years.

Is a UK annuity reported on Form 8938 or the FBAR?

It can be, and this is the part most often missed even by people who did report the income. The IRS comparison table at https://www.irs.gov/businesses/comparison-of-form-8938-and-fbar-requirements lists a foreign-issued life insurance or annuity contract with a cash value as reportable on both Form 8938 and the FBAR. The same page gives the FBAR test as an aggregate value of foreign financial accounts exceeding $10,000 at any time during the calendar year. For Form 8938 it gives higher thresholds for taxpayers living abroad: specified foreign financial assets above $200,000 at year end or $300,000 at any time for an unmarried taxpayer or one married filing separately, and above $400,000 at year end or $600,000 at any time for a married couple filing jointly.

A deferred annuity that still has a surrender or cash value therefore sits squarely within both regimes. A lifetime annuity already in payment, with no cash or surrender value, is a harder call. The IRS table speaks to contracts with a cash value, and it does not set out a separate line for a contract in payment with none. We treat this cautiously: we obtain written confirmation from the provider of whether any cash, surrender or commutation value exists, check the form instructions for the year in question, and record the reasoning. Whatever the conclusion for the annuity, the bank account that receives the payments is a foreign financial account and counts towards the FBAR aggregate in its own right. Form 8938 is attached to the income tax return, while the FBAR is filed electronically with FinCEN and is not filed with the return. Questions about excise tax on foreign-issued policies and about passive foreign investment company rules for investment-linked contracts are outside the scope of this article.

Worked scenario: three years of annuity income never reported

The following is an illustration only. The figures are invented to show the mechanics, the exchange rate is an assumption, and the life expectancy multiple is assumed and not taken from the IRS tables. A US citizen who has lived in London for over twenty years has never filed a US return. She holds two annuities. The first is a purchased life annuity bought with £600,000 of her own after-tax capital, paying £36,000 a year. Her provider certificate shows an exempt capital amount of £24,000 and a taxable amount of £12,000 a year. The second is a lifetime annuity bought with UK pension savings, paying £30,000 a year, fully taxed in the UK.

Assume a flat rate of $1.25 to the pound for every date, purely to keep the arithmetic readable. The purchased life annuity cost $750,000 and pays $45,000 a year. Assume a multiple of 22.0, giving an expected return of $990,000. The exclusion percentage is $750,000 divided by $990,000, which rounds to 0.758. The tax-free amount is $45,000 multiplied by 0.758, or $34,110 a year, leaving $10,890 taxable in the US. The UK, by contrast, taxed £12,000, or $15,000 at the assumed rate. On this annuity the UK has taxed more income than the US has, so the UK tax on it should more than cover the US tax on the same income.

For the pension annuity, assume she was never taxed in the US on any contribution and has no investment in the contract. The whole $37,500 a year is taxable in the US, and the whole £30,000 was taxed in the UK. Across the three catch-up years her US returns would show $135,000 of gross purchased annuity payments with $32,670 taxable, and $112,500 of pension annuity payments, all taxable. With UK tax paid at her marginal rates on both streams, the foreign tax credit would be expected to absorb most or all of the US tax, but that outcome has to be computed year by year. It cannot be assumed. Had the facts been reversed, with a smaller US exclusion than the UK capital amount, a residual US liability plus interest would be the likely result.

Which catch-up route fits: Streamlined Foreign Offshore Procedures or late returns?

For a UK-resident taxpayer whose failure was non-willful, the Streamlined Foreign Offshore Procedures are usually the route we prepare. The IRS sets out the terms at https://www.irs.gov/individuals/international-taxpayers/us-taxpayers-residing-outside-the-united-states. The key requirements are:

• Non-residency: a US citizen or green-card holder must have had no US abode and been physically outside the United States for at least 330 full days in at least one of the most recent three years for which the return due date has passed.
• Non-willful conduct: the failures must result from negligence, inadvertence or mistake, or from a good-faith misunderstanding of the law.
• Returns: delinquent or amended returns for the most recent 3 years with a passed due date, with all required information returns such as Form 8938. Form 1040 is used if no return was filed before, and Form 1040-X if one was.
• FBARs: delinquent FBARs for each of the most recent 6 years for which the FBAR due date has passed, filed electronically through FinCEN's BSA E-Filing System.
• Form 14653: a signed certification of eligibility and non-willfulness, with a copy attached to each return but not to the FBARs.
• Payment: the full tax and interest due must be remitted with the returns.
• Format: the returns are filed on paper to the dedicated address, with Streamlined Foreign Offshore written in red at the top of the first page of each return.

A taxpayer who complies is not subject to failure-to-file, failure-to-pay or accuracy-related penalties, or to information return and FBAR penalties, under these procedures. There is no offshore penalty on the foreign version. The IRS does note that penalties can still follow if an examination finds the original non-compliance was fraudulent or the FBAR violation willful, and that previously assessed penalties are not abated. If the instructions are not followed, the returns are processed in the normal course without the favourable terms.

Filing late returns outside the procedures is the alternative, and it suits a narrower group: for example, someone who filed every year, reported all accounts, and needs only to amend to add an annuity where the credit eliminates any additional tax. That route carries no certification and no built-in penalty protection. Unfiled information returns change the picture even where no tax is due: the IRS comparison page states a penalty of up to $10,000 for failing to disclose on Form 8938, with further amounts after IRS notice.

How do you rebuild year-by-year figures from provider statements?

Reconstruction is where most of the preparation time goes. For each annuity we assemble the same pack before any return is drafted:

• The original contract schedule, showing the purchase price, purchase date, annuity starting date, payment frequency and whether payments are level or escalating.
• Every annual provider certificate since the starting date, not only those for the three return years, so the US investment already recovered can be tracked.
• Written provider confirmation of any cash, surrender or commutation value at each year end, for the Form 8938 and FBAR analysis.
• Bank statements for the receiving account, to confirm net amounts received and the highest balance in each calendar year.
• UK Self Assessment calculations, so that tax paid beyond the provider's deduction is captured for the credit.
• For a pension annuity, the contribution history and any evidence of how contributions were treated on earlier US returns, if any were filed.
• A documented exchange rate policy, applied consistently to payments, UK tax and the purchase price.

What should you do next?

If you are a US citizen or green-card holder in the UK receiving annuity income and your US filings are incomplete, gather the contract schedule and every annual certificate first. We prepare the reconstructed returns, the General Rule computations, the foreign tax credit schedules, Form 8938, the FBARs and the Streamlined certification as one reconciled package. This article is general information on tax preparation and compliance and is not a substitute for a review of your own facts.

Related reading and tools

• US Tax Services & IRS Compliance
• UK Tax Services
• IRS Streamlined Filing
• UK Income Tax Calculator
• US Federal Income Tax Calculator

Every situation is different. Book a cross-border tax consultation to discuss how these rules apply to you.

Authoritative sources

IRS — Streamlined Filing Compliance Procedures

FinCEN — Report of Foreign Bank and Financial Accounts (FBAR)

HM Revenue & Customs

GOV.UK — Tax on foreign income

IRS — Foreign Earned Income Exclusion

IRS — Foreign Tax Credit

ICAEW

Chartered Institute of Taxation (CIOT)

AICPA

MoneyHelper (UK)