American citizens living in the UK face a complex interaction of U.S. and UK tax law as applied to their investments and retirement savings. The U.S. government taxes American citizens on their worldwide income based upon citizenship rather than residency. In addition to paying U.S. taxes, a U.S. citizen living in the United Kingdom may be exposed to UK income taxes assessed by the HMRC.
Prior to implementing any investment strategy an investor must always consider the tax implications that are created by being subject to two tax jurisdictions. Traditional U.S. financial planning strategies may be counter-productive for American citizens living in the UK. It is essential to always coordinate investment and financial planning decisions with both IRS and HMRC rules. Below is brief overview of twelve common U.S./UK financial planning issues that may be commonly encountered by American investors living in the UK.
1. Owning U.S./UK Compliant Investment Funds (U.S. Listed HMRC Reporting Funds)
A common investment mistake made by many American expats is owning non-U.S. financial products, commonly referred to as Passive Foreign Investment Companies (PFICs). PFICs commonly include non-U.S. listed mutual funds and non-U.S. listed exchange traded funds (ETFs). A U.S. taxpayer owning PFIC investments will face onerous taxes and compliance costs. Thus, for most U.S. citizens living abroad, owning PFICs should be avoided outside of qualified retirement accounts (IRAs, 401ks, and UK Company Pensions).
The UK imposes additional requirements that limit tax-efficient investments available to American expats. American investors paying UK tax on investments should focus on owning U.S. listed investments that are registered with the HMRC. Using these special “UK-reporting funds” ensures that favorable UK capital gain treatment is given to these investments. Investment gains from U.S. funds not registered with the HMRC will be considered Offshore Income Gains (OIG) and face the highest UK tax rates. There are many U.S. listed funds available that are HMRC compliant and since they are U.S. listed, these funds (mostly ETFs) will not be classified as PFICs. American expat investors in the UK should familiarize themselves with this list of HMRC offshore reporting funds.
2. Understanding UK Company Pensions, Personal Pensions (SIPPs), and Individual Savings Accounts (ISAs)
New pension laws in the United Kingdom require mandatory enrollment in a company sponsored defined contribution pension for most UK employees. This means that many Americans expats in the UK need to understand the tax implications of participating in a non-U.S. pension plan. The good news is that the extensive U.S.-UK double tax treaty allows for pre-tax contributions and tax deferral in a UK company sponsored pension. This double tax treaty also simplifies the U.S. tax reporting of a UK company pension.
Contributing to a UK company pension is a great way to use excess foreign tax credits generated by higher UK tax rates. In addition to using a UK company pension, a personal pension (SIPP) may be an additional way for American taxpayers to utilize excess foreign tax credits. However, caution is warranted because a SIPP is not clearly defined in the U.S.-UK double tax treaty and may require specialized tax reporting to achieve a net tax reduction in both countries. Individuals should consult with a qualified U.S./UK tax preparer before using a SIPP as part of a cross-border financial planning strategy.
On the other hand, a UK individual savings account (ISA) is not considered a pension account by the IRS. Growth and income generated by investments in an ISA for UK tax purposes will be tax free, but all income and gains are taxable by the United States. Further, any collective investments such as non-U.S. listed mutual funds or ETFs may be classified as PFICs. Owning PFICs in an ISA is an expensive mistake often made by U.S. expat investors in the UK and a large detriment to proper U.S./UK cross-border financial planning.
3. Use of U.S. Retirement Accounts While in the United Kingdom (IRAs, 401(k), Roth IRAs)
American citizens moving to the UK often arrive with a variety of U.S. retirement accounts such as 401ks, IRAs, and Roth IRAs. U.S. expats will have no tax issues maintaining these accounts while residing in the UK. However, it is important to check if the investment custodian holding these accounts has implemented U.S. expat investment account restrictions.
In a similar fashion to the protections afforded to UK pensions, the extensive U.S.-UK double tax treaty protects the tax qualified nature of U.S. retirement accounts (including Roth IRAs). Even though these 401k, IRA, and Roth IRA accounts have tax treaty protections, it may not make sense for Americans living in the UK to continue to contribute to these accounts. Higher UK tax rates might make IRA contributions tax inefficient and lead to double taxation for most American expats in the UK.
4. Deciding to Claim the Arising Basis or Remittance Basis of Taxation (UK Domicile/Deemed Domicile) as a U.S. Taxpayer
The amount of time spent in the UK dramatically impacts an American expat’s financial planning strategy. Understanding UK residency and domicile tax rules is essential for Americans moving to the UK. There may be some advantages for newly arrived American expats in the UK to shelter some investments from UK taxation through special tax elections and financial planning strategies.
For a UK resident “non-dom” (non-domiciled) individual, there is an option of being taxed on two bases: the arising basis and remittance basis. Arising basis taxpayers are subject to tax on their worldwide assets and income. UK residents electing the remittance basis are only subject to UK income tax on UK source income (usually only UK wages) and gains on UK property as they occur. In addition, they will be subject to UK tax on non-UK source income and gains if “remitted” to the UK. The remittance basis must be expressly claimed in most cases and is subject to an annual charge after the first seven years.
Long-term residency and domicile in the UK require the most planning. For investors with significant wealth accumulated prior to moving to the UK, there are numerous strategies than can greatly reduce UK taxes on investments. UK resident, non-domiciled individuals may be able to claim the remittance basis for up to 15 years during which time significant gains may be untaxed by the HMRC. Plan ahead as many U.S. expats stay in the UK longer than originally anticipated!
5. Managing Cross-Border Currency Risk for Americans in the UK
The strong U.S. Dollar (USD) is great for recent UK arrivals moving funds across the Atlantic to Pound Sterling (GBP) to buy houses and other UK assets. However, uncertainty in the exchange rate also causes American expats living in the UK who are paid in GBP great stress about which currency to save and invest in. It is essential to develop a long-term plan for cash reserves and a portfolio that focuses on matching current assets with future liabilities. For example, an individual planning to retire in the UK should be more exposed to GBP investments than someone who may retire back in the United States and spend USD.
Currency swings also create tax implications for U.S./UK investors. An investor must calculate capital gains, interest, and dividend payments in both USD and GBP. Given the appreciation of the USD against most major currencies (including GBP), investors may face surprise UK capital gains tax on USD linked investments as demonstrated below with a UK taxable sale of a U.S. treasury bond:
In this example, the appreciation of the USD against the GBP created a gain that will be taxed by the HMRC. Many investors and advisors (including robo-advisors and separate managed accounts (SMAs)) may optimize investments for U.S. tax purposes but neglect to consider any UK tax implications of portfolio changes. This may create a unfortunate surprise at UK tax time!
6. Buying UK Real Estate as an American Expat
It is common for long-term American expats in the UK to buy property. One difference from the U.S. tax system is that the UK does not charge any capital gains tax on the sale of principal residences. The HMRC collects revenue from property transactions by assessing a Stamp Duty & Land Tax (SDLT). However, an American citizen is still subject to U.S. capital gains tax on the gain from the sale of their principal residence over $250,000 ($500,000 if filing jointly) even if that residence is in the UK. One potential strategy to avoid extra tax is to divide ownership between a U.S. and non-U.S. spouse as to optimize the amount that may qualify for the U.S. exemption.
Another area U.S. expatriates must be mindful of is refinancing or paying off a UK mortgage. Given the appreciation of the USD against the GBP, this transaction may lead to large U.S. currency gains that are taxable as ordinary income by the IRS. Below is an example showing the potential implications of a U.S. currency gain on a foreign mortgage:
In the above example, the IRS will see a debt relief due to the currency fluctuation that will be taxed, even if there is no sale of the asset. Be cautious with floating mortgages (shorter term loans with variable rates), which are common in the UK, to avoid the situation illustrated above!
7. Understand other U.S./UK Cross-Border Tax Issues
There are several major structural differences between the U.S. and UK tax systems. The UK tax system uses a fiscal year that runs between Apr. 6th to Apr. 5th of the following year. The United States uses a calendar year for tax reporting. Unlike in the United States, there is no system of joint filing in the UK and spouses must each file their own tax declarations. On the U.S. tax side, there are numerous additional U.S. expat tax forms which must be completed annually:
- FBAR (FinCen 114)
- FATCA (IRS Form 8938)
- Passive Foreign Investment Companies (IRS Form 8621)
- Foreign Pensions and UK Trusts (IRS Form 3520)
If an American expat receives equity compensation such as incentive stock options (ISOs) or restricted stock units (RSUs), there can be significant additional complexity on filing a U.S./UK tax return. Preparing a tax return is even more complicated if a U.S. taxpayer owns a business classified as a controlled foreign corporation (CFC). Speak to a qualified U.S./UK expat tax preparer if you are in one of these more complicated situations.
8. Review Your U.S. Estate Plan After Moving to the UK and Pay Careful Attention to Trusts
Estate plans do not travel well across borders and U.S. estate plans utilizing trusts may create extra UK tax. Trusts may incur a UK tax charge upon entry/exit of the United Kingdom. This means that U.S. revocable living trusts (funded) and U.S. life insurance trusts (ILITs) have potentially serious UK tax ramifications. It is imperative that an American living in the UK be cautious about serving as trustee of any U.S. trust as well, as there can be drastic consequences to settling a trust while UK domiciled or deemed domicile.
U.S. citizens are still subject to U.S. estate taxes, even when living in the UK. The United States imposes income and transfer (estate/gift) taxes based primarily upon citizenship. The maximum rate of federal estate tax and gift tax is 40%. However, with a $11.4estate tax exemption for individuals, many U.S. citizens are under the exemption and not overly concerned with planning for this tax. See more on international estate planning for U.S. expats.
9. Planning for UK Probate and Inheritance Tax (IHT) as a U.S. Citizen
The UK has much lower estate tax (IHT) thresholds than the United States. The exemption amount is only 325,000 GBP per person (2018/2019). The IHT tax rate will be 40% on global assets for UK domiciled or deemed domiciled individuals. Similar to the United States, transfers between spouses are not subject to IHT. There are also several nuances to the calculation of IHT when passing a primary residence to a child or donating to charity.
Americans planning a long-term stay in the UK should consider structuring assets outside the UK inheritance tax net. For example, UK excluded property trusts and term life insurance are powerful planning tools for individuals who may not remain in the UK permanently. In addition to planning for IHT, American expats should revisit their wills and other estate documents to ensure assets will pass as planned if they are domiciled in the UK at death. The U.S. and UK have similar probate laws, but it is always best to have a primary will written in a jurisdiction of primary domicile to ensure a smooth transfer of assets at death.
10. College Savings – U.S. Expat 529 Plans while in the UK
Savings for college is important for many American expat parents. The good news is that most top UK and many European universities are eligible for 529 funds (100+ Schools in UK). However, long-term UK residents should be careful about maintaining 529 accounts while being a tax resident in the UK. The HMRC does not recognize the special tax-free nature of 529 college savings accounts and imposes taxes on investment gains. A potential strategy is to have a trusted person establish the 529 college savings account in the United States and make contributions as a U.S. expat living in the UK.
11. Planning Implications of a Non-U.S. Spouse Married to an American in the UK
Many Americans may find themselves in a mixed nationality marriage were one spouse is not a U.S. citizen. This presents some planning opportunities and pitfalls. There may be some advantages to keeping the non-U.S. spouse outside of the U.S. tax system. The UK has some attractive capital gains reliefs that can be preserved by holding assets in the non-U.S. person’s name. Further, a non-U.S. spouse should take full advantage of special UK tax advantaged accounts such as SIPPS and ISAs. Once a decision is made to bring a non-U.S. spouse into the U.S. tax system, the election is difficult to revoke.
12. Leaving the UK: The Importance of Breaking UK Domicile
Many American expats may decide to leave the UK one day and return to the United States or elsewhere. For an English domiciliary or deemed domiciliary to lose their English domicile status, they need to settle permanently in a new jurisdiction outside the UK.
For Americans returning home, each U.S. state is considered a different jurisdiction. Individuals need to be mindful of migration between U.S. states (i.e. moving from New York to Florida) because English domicile could revive in transit and there is a 3-year tail to lose English domicile. During this 3-year period, there remains exposure to IHT and individuals should be very careful about engaging in estate planning with funded trusts until they are certain UK domicile is lost.
Conclusion: Making the Most of Your Time in the UK as an American Expat
U.S. taxpayers living, working or investing while living in the UK have unique financial planning needs. When dealing with taxation in two jurisdictions, it is vital to work with an expert American expat financial advisor who understands the interaction of the U.S. and UK tax systems to create a global investment strategy. The most successful outcome is a portfolio that is optimized for both UK and U.S. tax codes and reporting.
Financial planning for Americans abroad is complex but does not have to be overwhelming. Round Table Wealth Management is an independent wealth advisory firm with experience in working with global families who face these complex cross-border circumstances. We coordinate investment strategy and tax planning with a goal to optimize our client’s after-tax returns and preserve wealth. As fiduciaries, we help our U.S./UK expatriate clients plan and execute their finances through the unique challenges of living abroad.