US Families | January 25, 2024
Written by Ben Lightfoot, CFP™
The appeal of opening and contributing to an Individual Savings Account (ISA) is evident for UK-only residents and taxpayers, given the tax-free status of interest, dividends, and gains within these accounts. However, the landscape is nuanced for US taxpayers residing in the UK. This blog delves into the practicality of including a UK ISA in the overall financial strategy of an American living in the UK.
Among the different kinds of ISAs available, we focus on two common types: cash ISAs and stocks and shares ISAs. Residents in the UK can contribute up to £20,000 to these ISAs for the 2023/24 UK tax year, provided they are 16 years old for a cash ISA or 18 years old for a stocks and shares ISA. Cash ISAs are a good solution to keep money earmarked for emergencies and other short-term spending needs, while stocks and shares ISAs are appropriate to keep money reserved for longer-term goals. If your cash or stocks and shares ISA is ‘flexible’, as confirmed by the provider, you can withdraw money and put it back in the ISA during the same tax year without reducing your current year’s £20,000 allowance.
For US taxpayers, it is important to understand that although ISAs are tax-free accounts from a UK perspective, the US does not recognize the tax-free status of an ISA. From a US perspective, an ISA is considered a general taxable account, and any interest, dividends, or gains are subject to US taxation. The tax savings for US taxpayers in the UK lies in the difference between the relevant US and UK income and capital gains tax rates.
For example, consider a US taxpayer in the UK with an earned income of £125,141 in the 2023/24 UK tax year and is therefore classified as an additional rate taxpayer. An additional rate taxpayer is not afforded a personal savings allowance (i.e. an allowance on interest that can be earned tax-free) and would, therefore, pay 45% in UK income tax on interest earned in a general taxable account. However, they would pay no UK income tax for interest earned in an ISA. From a US tax standpoint, the same individual would pay either 24% or 22% in US income tax on the interest earned within an ISA. Based on an income of £125,141 (approximately $159,077 at a GBP/USD exchange rate of 1.27), the 24% marginal tax rate would apply if the individual is a single US tax filer and the 22% marginal tax rate would apply if the individual is a married joint US tax filer. So, as you can see, although the interest in the ISA is not tax-free for this individual, there is a meaningful difference in the marginal tax rates in the US and the UK. The individual would achieve tax savings of the difference between the 45% UK income tax rate and either the 24% or 22% US income tax rate. This results in a 21% tax savings for a US single tax filer or a 23% tax savings for a US joint married tax filer.
Opening and contributing to a cash ISA poses minimal drawbacks and is generally advantageous for Americans, particularly those with a high income in a higher interest rate environment. However, caution is advised for those considering a stocks and shares ISA. In particular, US taxation on investments in offshore collective investment funds, classified as Passive Foreign Investment Companies (PFICs), may outweigh potential tax savings. Unfortunately, US mutual funds and ETFs, which are tax-efficient from a US standpoint, are not available to purchase through UK ISA providers, which means it is important for US taxpayers to purchase only individual stocks and bonds within a stocks and shares ISA. This approach has drawbacks from a risk standpoint, as acquiring the number of individual stocks and bonds needed to be sufficiently diversified is labour-intensive, expensive due to trading and transaction costs, and requires active and ongoing management.
In conclusion, in our view, incorporating a UK ISA into the overall financial strategy of an American in the UK holds merit. Nevertheless, due diligence is essential. Consultation with a US/UK dual-qualified wealth manager and tax advisor is recommended to tailor the approach based on individual circ*mstances and maximize potential tax savings.
The Legal Stuff
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The views expressed herein do not necessarily reflect the views of MASECO as a whole or any part thereof. All investments involve risk and may lose value. The value of your investment can go down depending upon market conditions and you may not get back the original amount invested. Your capital is always at risk. Information about potential tax benefits is based on our understanding of current tax law and practice and may be subject to change. The levels and bases of, and reliefs from, taxation is subject to change. The tax treatment depends on the individual circ*mstances of each individual and may be subject to change in the future.
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