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Unlocking Tax-Free Investing for US Persons

Moneymagpie Team 8th Jul 2024 No Comments

Reading Time: 4 minutes

There is never a better prompt when entering a new UK tax year to take stock and make sure allowances for tax wrapped accounts have been maximized into an Individual Savings Account (ISA).

However, saving and contributing into UK tax wrapped products as a US person living in the UK becomes more complicated especially when it comes to ISAs.

Are there other options available to US persons living in the UK to save tax free?

Firstly a reminder of an ISA and what it is

ISAs are tax efficient saving products that allow UK residents to contribute up to £20,000 a year of after-tax income. There are a number of different ISAs including Stocks and Shares, Lifetime, Cash and Junior ISAs. In this article we focus on the Stocks and Shares ISA.

In a Stocks and Shares ISA you can invest in stocks, bonds and funds and your investments will grow UK tax free and further down the road you can also withdraw the monies tax free. Stocks and Shares ISAs are very flexible and there are no limits on when or how much you can withdraw. This type of ISA can be a good option for investors with a medium to long term investment time horizon.

The more risk one takes the more you might benefit from compounding tax free growth. However increased risk generally means more portfolio volatility so it’s important to invest with a long-term investment time horizon, this will help to increase the odds of having a more successful investment experience.

However, for US persons with a US tax filing requirement the benefit of shielding the underlying income and gains from taxation is taken away because the US treats an ISA like a normal brokerage account (the wrapper doesn’t exist) and therefore any income or gains generated within the ISA are taxable in the US.

It gets worse than this, if Americans invest in funds within the ISA, it is likely these funds will be deemed Passive Foreign Investment Companies (PFICs) and will be taxed very punitively by the US. It is therefore recommended that funds are avoided. It is possible to invest in single stocks and bonds which won’t be taxed punitively by the US but they will still be taxed by the US.

One common way that US persons can continue to invest tax free is with a Roth IRA.

What is a Roth IRA?

A ‘Roth IRA is a type of Individual Retirement Account. Like an ISA, a Roth IRA can be funded with after-tax money and it provides tax exempt growth. Roth IRA can only accept cash contributions.

To make a contribution into a Roth IRA there are certain requirements that need to be adhered to; including you need to have earned income and you need to check your filing status and Modified Adjusted Gross Income because this can impact how much you can contribute. If your earnings are over the threshold then you may not be able to contribute. Further information about the thresholds can be found on the IRS website*

If you are able to contribute into a Roth IRA, for 2024 it is possible to contribute $7,000 if you’re under age 50 and $8,000 if you’re age 50 or older. Even though the amount you can contribute into a Roth IRA is not as generous, contributing the maximum each year can pave the way for compound growth over time.

If your earnings push you over the threshold whereby you are not able to make a direct Roth IRA contribution there is the potential opportunity to get money into a Roth IRA via a ‘backdoor’ Roth IRA contribution. This is only available to those who do not have other existing IRA balances.

To execute the ‘backdoor’ Roth IRA contribution an individual would need to make a current year non-deductible Traditional IRA contribution of say $7,000 (the current allowance for someone under age 50) and then immediately convert the balance over to a Roth IRA via a Roth IRA conversion. As the original contribution did not receive tax relief, the conversion does not attract additional income tax and the funds end up in the Roth IRA as though you were able to make the contribution directly. Hence the term ‘backdoor’ Roth IRA contribution. The benefit of getting funds into the Roth IRA is the fact that money held within this type of plan will be considered tax exempt provided qualified distributions** are made in the future.

As Roth IRAs are recognised under the US/UK tax treaty it is important to note that you don’t need to be concerned about the underlying investments because the Roth IRA tax wrapper is recognised from both a UK and US perspective.

Conclusion

Stocks and Shares ISAs are great savings vehicles for UK persons but can add complexity if used by a US person. Where US persons in the UK are accumulating assets, have earned income and want to benefit from tax exempt compounding on any investment growth.

* https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2023

* https://masecoprivatewealth.com/

**Qualified distributions – to avoid being subject to a 10% early withdrawal penalty, withdrawals must be 1) taken after age 59.5 and 2) taken after a five-year holding period

Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.

 

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Jasmine Birtles

Your money-making expert. Financial journalist, TV and radio personality.

Jasmine Birtles

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