The second article of the Roadmap is about US/UK Tax.
“Don’t let the tax tail wag the investment dog,” in other words don’t let tax decisions drive your investment choices.
But what if your dog has two tails and they’re waggling in the opposite direction? Being an American living in the UK changes everything, something tax effective in one jurisdiction could be the complete opposite in another. Let’s have this investment dog be united with its tax tail!
Understanding the basics of US/UK Tax
Joshua Moss sits down with Annie Hughes from Blick Rothenberg to discuss four of the main areas that Americans residing in the UK need to understand before committing to the plan:
01 Residency, remittance vs arising
UK residency is dependent on the Statutory Residence Test, a huge piece of legislation spanning hundreds of pages.
For those that are resident and non-domiciled in the UK, there are two ways in which they may be taxed. The first is on the arising (worldwide) basis, meaning worldwide income and gains will be subject to tax in the UK.
The other method of tax, available only to non-domiciled individuals, is the remittance basis. For most individuals, a remittance basis claim will need to be made to enable them to avoid UK tax on monies not generated in or remitted to the UK. There may be a cost to this depending on your years of UK residency.
For US taxpayers, filing on the remittance basis can create a saving, but requires careful account management and future planning.
There are many elements of currency that need to be considered for Americans living in the UK. A lot of these are practical; ‘do I have sufficient monies to cover costs and tax payments in each country?’. Others are about looking forwards; ‘where will I need funds when I retire?’. Some are about investment needs, which I won’t comment on, and then there is tax.
The Internal Revenue Service (IRS) determines the functional currency of each US taxpayer to be USD. As such, certain foreign exchange movements can create an unexpected tax liability for those living overseas. We most commonly see this in relation to loans and mortgages, but it’s worth being aware of the additional tax burden this can add to investments.
03 Tax Periods
The UK tax year runs from the 6th of April to the following 5th of April, whereas the US follows the more straightforward calendar year.
This essentially gives us two year-ends to consider for each of our clients. At these year-ends, you must consider gain and loss positions, pension contributions, gifting, and charitable contributions.
04 Foreign tax credits
The different tax periods can also cause issues when claiming foreign tax credits.
Individuals file either on the paid or accrued basis. This means paying tax to HMRC early to ensure tax is physically paid in the same calendar year that income or gain arises. Towards the end of the US tax year, we spend a lot of time looking at UK taxable income and gains arising in the calendar year, estimating the US tax and ensuring this is paid to HMRC ahead of the 31st of December.
For individuals who file on the accrued basis, tax payments do not have to be made however, credits cannot be claimed until the close of the UK tax year. This causes a 9-month period during which an individual may not have sufficient tax credits. The IRS recently updated their guidance for accrual basis taxpayers, and anyone taking non-fiscal accrual positions should discuss these with their tax advisor.
As an American, should I be utilising any tax allowances whilst in the UK? The simple answer is yes, utilising any tax allowances (no matter how marginal in relative size) is worthwhile as it gives your assets the chance to work harder.
Let’s start with UK pensions:
They act in a similar fashion to a traditional IRA; untaxed money is put into an account and grows free of any tax. Currently, each person has an allowance of £40,000 subject to earnings and may have the ability to carry forward any unused allowance from the previous three UK tax years.
Some important benefits:
- This account is usually seen as a retirement pot from the US standpoint so a great way to build tax effective growth in both jurisdictions,
- Pensions are outside of an estate for UK inheritance tax purposes and have favourable death benefits applicable to them so are an important tool in estate planning,
- At age 55 (57 in 2028), you can access 25% of funds tax free, with the remainder subject to marginal income tax (which in most cases is determined by where you are tax resident at the time.)
They act in a similar fashion to a ROTH IRA (individual US retirement account), after tax money is put into an account and can grow free of any UK tax. The ISA wrapper is seen as ‘see through’ by the IRS, which means they will treat an ISA like a regular brokerage account. There are still benefits from utilising the current £20,000 allowance.
Whilst US tax rates remain lower than in the UK, having funds subject to US tax represents a marginal benefit which is compounded over a long period of time. There may also be an opportunity to use foreign tax credits to reduce the overall tax.
What about my US pension?
The most common form of US pensions are 401(k)s and traditional IRAs. 401(k) plans can be rolled into a traditional IRA tax free, with the usual rationale being that IRAs have a larger universe of investment opportunities.
Both accounts are not qualifying UK pensions, which means you cannot claim any UK tax relief on contributions. However, the UK will not tax any income & or gains arising on funds held within the 401(k)/IRA proving them to be an effective part of any plan.
The main pitfalls
Passive Foreign investment Companies
Or more commonly known as PFICs. Broadly these are offshore (to the US) wrapped investments that the IRS do not have visibility of.
Certain distributions and gains are taxed at the highest rate of Federal income tax over the years of the investment, and interest charges are also applied to negate any perceived deferral benefits. As such, these are not typically tax efficient investments.
Similarly, HMRC have punitive tax rates for offshore funds that do not provide annual information to HMRC. Gains from these funds are known as Offshore Income Gains and are taxed as income, meaning the tax rates applied can be as high at 45%.
Short term vs long term gains
In the UK capital gains taxes are taxed at 10/20%, depending on the individual’s other income, with the exception of residential property and carried interest, which are taxed at 18/28%.
In the US, gains on assets held over one year are taxed at 20%, whereas gains held less than one year are taxed at ordinary income rates. This issue can be compounded even further with the fluctuations in foreign exchange