U.S. citizens are in the unenviable position of being taxed on their worldwide income and gains. This simple fact causes many challenges for Americans when making seemingly simple financial decisions. Understanding the key pain points and questions to ask along the way can make all the difference.
In this short post, we will give you a brief overview of the basic principles of saving in a stocks and shares ISA.
The Individual Savings Account (or ISA as it is better known) is a very efficient savings vehicle for U.K. taxpayers. Unfortunately, for those who also have a U.S. tax filing requirement much of the benefit goes away.
(Please note this article shall focus on Stocks & Shares ISAs only. For more information on different types of ISAs see here.)
The ISA is a wonderful thing for savers. Introduced in 1999, it allows individuals to contribute cash savings (post tax) into an account that grows free from income and capital gains tax, forever (or until death). Even better, you can take out the money whenever you want with no penalty.
Adults (16 and older) are allowed to contribute up to £20,000 into an investment ISA each tax year. This may not seem like a lot, but if you do this each year for many years you can see the power of compounding at work (assuming an 8% return).
| Time | Future Value |
|---|---|
| 1 Year | 21,600 |
| 5 Years | 119,509 |
| 10 Years | 292,930 |
| 15 Years | 547,742 |
| 20 Years | 922,144 |
| 25 Years | 1,472,265 |
| 30 Years | 2,280,572 |
Source: Brown Advisory calculations
Brilliant! Where do I sign up?
Here’s the bad news for U.S. taxpayers. Unfortunately, the U.S. treats an ISA just like any other taxable account, meaning you are subject to U.S. income and capital gains tax on all activity within the ISA.
Furthermore, there are strict rules about what investments are allowed to be held in an ISA and not many U.S./U.K. friendly fund structures are suitable (for example U.S. mutual funds with U.K. 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 U.S. perspective.1
This leaves Americans with limited investment options: namely direct holdings in stocks and bonds and U.S. listed ETFs with U.K. reporting fund status (if they are available on your ISA manager’s platform). These two factors remove many of the benefits of having an ISA for U.S. taxpayers. While there could technically be some tax arbitrage available due to differing tax rates between the U.S. and U.K., the lack of flexibility around what you are allowed to own tax efficiently makes it less attractive, unless you plan to pick solely individual stocks.
Is there any good news?
There is a similar structure in the U.S., namely the Roth IRA, which has similar benefits to an ISA. All contributions grow free from income and capital gains tax and in addition, there are no taxes or penalties if you want to take out the capital you have put in (excluding income and gains). Once you reach age 59½, you can take out as much as you like (including income and gains) without any tax or penalties.
And here’s the kicker:
The U.K. 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: you need to have earned employment income in order to qualify and there is an income threshold where you no longer become eligible (see here for the current figures and additional qualifications).
If you meet the above qualifications, you can save $6,500/year ($7,500 if over 50)2.
While not as generous as the U.K. ISA allowance, it is still meaningful over a long period of time. I include the same chart as above (assuming $6,500 annual contributions and an 8% return).
| Time | Future Value |
|---|---|
| 1 Year | 7,020 |
| 5 Years | 38,840 |
| 10 Years | 95,202 |
| 15 Years | 178,016 |
| 20 Years | 299,697 |
| 25 Years | 478,486 |
| 30 Years | 741,186 |
Source: Brown Advisory calculations
Conclusion
While ISAs are a great savings vehicle for most U.K. taxpayers, the benefit largely disappears for individuals with a U.S. tax filing requirement. To avoid potential issues down the road speak to your friendly US/UK advisers (accountants and investment managers) before opening up and funding ISAs.
Whether you plan to spend a few years, a few decades, or the rest of your life outside the U.S., Brown Advisory can deliver a comprehensive cross-border investment plan for you and your family that can move with you wherever life may take you. Learn more >
Billy Mathews, a U.S. expat himself, is a Portfolio Manager in our London office and helps U.S.-connected clients build U.S./U.K. tax efficient investment portfolios to meet their long-term goals and objectives.
1 PFICs are a separate topic for another day, but in general they should be avoided at all costs.
2 2023 numbers.
This material is not intended to be, and shall not be construed as being, investment advice. Investment decisions should not be made on the basis of it. Past performance is not indicative of future performance and there is a risk that some or all of the capital invested may be lost. The information contained herein is based on materials and sources that we believe to be reliable. We make no representation, either express or implied, in relation to the accuracy, completeness or reliability of that information. The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. Brown Advisory does not provide tax advice.
Any business or tax discussion contained in this communication is not intended as a thorough, in-depth analysis of specific issues. Brown Advisory does not render legal or tax advice. Prior to making an investment decision, a prospective investor should consult with its own legal, tax, accounting and other advisors to determine the potential benefits, burdens, and other consequences of such investment.