Should US taxpayers living in the UK use ISAs?

US citizens and Green Card holders are in the unenviable position of being taxed on their worldwide income and gains, writes Billy Mathews, portfolio manager at Brown Advisory.

This simple fact creates many challenges for Americans living in the UK when making seemingly simple financial decisions. Being an expat myself, I’ve navigated these issues first-hand so I understand the difficulties and know the right questions to ask that can make a difference.

One area of complexity that comes up frequently with US-connected persons living in the UK is the Individual Savings Account (Isa).

An ISA is a highly efficient savings vehicle for UK taxpayers, but unfortunately, for those who also have a US tax filing requirement, much of the benefit goes away.

All US citizens and Green Card holders, regardless of residence, are taxed on their worldwide income and gains. This includes ‘Accidental Americans’, or those born to US citizen parents (with eligibility to pass on citizenship to their children), even if they have never registered as a citizen, lived in the US, or have a US passport.

How are Isas treated for US taxpayers?

Unfortunately, the US treats an Isa just like any other taxable account, meaning US citizens are subject to US income and capital gains tax on all activity within the Isa.

Furthermore, there are strict rules about the types of investments that can be held in an Isa and there are no US/UK friendly fund structures that are suitable or available on the Isa platforms (for example US mutual funds or ETFs with UK reporting fund status).

Many Americans fall into the trap of opening an Isa and investing in an array of available fund options. Inevitably, these funds are classified as PFICs (Passive Foreign Investment Companies) and carry very punitive tax from a US perspective.

This leaves Americans with limited investment options within an Isa: namely direct holdings in stocks and bonds.

For US taxpayers, these two factors remove many of the benefits of investing in an Isa. While there could technically be some tax arbitrage available due to differing tax rates between the US and UK, the lack of flexibility around what can be held in this tax efficient wrapper makes it less attractive, unless the investment strategy is solely to select individual stocks and bonds.

Is there any good news?

There is a comparable tax efficient structure in the US, namely the Roth IRA, which has similar benefits to an Isa. All contributions grow free from income and capital gains tax and there are no taxes or penalties for withdrawing capital that has been put in (excluding income and gains).

On reaching the age of 59 and a half, as many withdrawals as are needed can be made (including income and gains) without any tax or penalties.

And here’s the kicker: the UK recognises Roth IRAs as qualified retirement plans under the double tax treaty, which means that they are truly tax-free on both sides of the pond.

A few additional things to note regarding Roth IRAs: earned employment income is required in order to qualify and there is an income threshold at which point individuals are no longer eligible (see the IRS website for the current figures and additional qualifications).

If the above qualifications are met, US taxpayers can save $6,500/year ($7,500 if over 50).
While not as generous as the UK Isa allowance, it is still meaningful over a long period of time, as highlighted by the chart below which assumes $6,500 (£5,217, €5,922) in annual contributions and an 8% return.

Roth IRA savings for US taxpayers

So, while Isas are a great savings vehicle for most UK taxpayers, the benefit largely disappears for individuals with a US tax filing requirement.

Life is unpredictable and despite the best intentions to plan for the future, things often change. It seems very common for Americans to come to the UK for just a few years, only to wake up 15 years later with a family, a house, and a very expensive and complicated tax situation to untangle.

By maintaining flexibility and seeking the appropriate advice early on, a lot of mental (and financial) pain and unnecessary complications can be avoided.

This article was written for International Adviser by Billy Mathews, portfolio manager at Brown Advisory.