For American expats in the UK, make sure you understand these important issues for managing your wealth.
The UK is one of the most popular European destinations for American expats. As an American expat in the UK, an unexpected challenge is saving and investing your wealth wisely.
UK-based clients of Creative Planning International have the complex interaction of U.S. and UK laws, regulations, and taxes managed for them every day. In this article, we highlight common investment management, financial planning, and estate planning concerns that Americans face living in the UK. If you’re an American expat or an American considering moving to the UK, this guide is for you.
This article covers:
- The UK/U.S. Investment Conundrum
- Problems maintaining a brokerage account in the U.S.
- Using only treaty acknowledged/protected accounts
- Understanding pension account differences
- Choosing the arising basis or remittance basis of taxation
- Considerations for estate/inheritance tax planning
- Using trusts and wills
1. The UK/U.S. Investment Conundrum
The UK and the U.S. have modern comprehensive income tax and estate and gift tax treaties. We’ll look at these treaties in more detail later. For now, you should know that these treaties do not alleviate a conflict between how capital gains from investments are treated by each country. Each country has very different rules about when a gain on an investment will be considered a capital gain, and therefore subject to 0%, 15% or 20% capital gains tax in the U.S., or 20% capital gains tax in the UK (known as CGT). This investment conundrum is the number one investment trap to avoid for U.S. taxpayers living in the UK.
Passive Foreign Investment Companies (PFICs)
“U.S. persons” (U.S. citizens and U.S. lawful permanent residents, i.e. Green Card holders) are uniquely subject to ‘citizenship’-based taxation. Therefore, if you are a U.S. person, no matter where you reside, you are required to file U.S. federal income taxes annually—even if you can exclude your earned income—and stay compliant with U.S. tax laws and regulations.
The most significant tax law and regulations, from a wealth management perspective, are those concerning Passive Foreign Investment Companies (PFICs). PFICs (for example a non-U.S. mutual fund) are taxed very harshly under U.S. law. Tax rates and interest charges can eliminate any gain on the investment. PFICs also trigger annual tax filings that, according to IRS estimates, can take over 20 hours per form each year to complete. Each PFIC requires a separate filing. Additionally, as PFIC gains are not considered capital gains, you cannot use losses from a PFIC, or another capital loss, to offset gains in PFICs you own.
For this reason, you’ll want to avoid buying UK or other European funds, all considered PFICs, and stick with buying U.S. funds that are exempt from PFIC rules. See: Why Americans should avoid owning shares in a non-U.S. mutual fund for more details on PFICs.
Approved Offshore Reporting Funds
The problem doesn’t stop there. The UK has rules similar to U.S. PFIC regulations. In the UK, to obtain Capital Gains Tax treatment from Her Majesty’s Revenue and Customs (HMRC), you must take care in choosing your investments. Capital gains in the UK are taxed differently from other income, such as your salary, and receive a £12,500 annual capital gains tax-free allowance. Only gains in excess of this amount are taxed, in most cases, at a 20% CGT rate. This is often half the income tax rate of 40%-45%.
On the other hand, U.S. ETFs will only obtain CGT treatment from HMRC if they qualify as Approved Offshore Reporting Funds. If your investments do not qualify as approved offshore reporting funds, in addition to gains being taxed at your marginal income tax rate, losses in those ‘non-reporting’ funds cannot be used to offset gains in other non-reporting funds.
The combination of these two conflicting taxation rules creates a critical investing trap to avoid for U.S. taxpayers living in the UK.
This just means you need an advisor who already knows about this issue and can create a portfolio that is compliant with the requirements in both jurisdictions.
Thankfully, for a U.S. or UK retirement account or pension that is qualified by the U.S.-UK income tax treaty, this PFIC/approved offshore reporting fund conundrum is not an issue as such accounts are considered opaque and their contents are not of concern to the tax authorities. See more on treaty qualified accounts below.
2. Problems maintaining a U.S. brokerage account
Many U.S. firms have stopped providing services directly to retail clients who reside outside the U.S. Many U.S. firms will even proactively close your account when they find out you live abroad. Read more on: Why U.S. brokerage accounts of American Expats are being closed.
UK law implementing an EU directive known as MiFID II (the UK enabling legislation remains in force post-Brexit) contains a clause that allows U.S. expats and others to buy U.S.-based investment funds as long as they work with an experienced non-EU registered investment advisor who purchases U.S. funds on their behalf.
Excerpt from MiFID II:
(111) The provision of this Directive regulating the provision of investment services or activities by third-country firms in the Union should not affect the possibility for persons established in the Union to receive investment services by a third country firm at their own exclusive initiative. Where a third-country firm provides services at the own exclusive initiative of a person established in the Union, the services should not be deemed as provided in the territory of the Union.
In short, a U.S.-based firm like Creative Planning that is willing to accept clients residing in the UK can provide services to you directly. This allows us to deliver investments that are both U.S. and UK-compliant.
3. The benefit of the U.S./UK income tax treaty
The U.S. and UK are party to three separate treaties/agreements around 1) income tax, 2) estate and gift (inheritance) tax, and 3) Social Security (State Pension) that are intended to help residents avoid double taxation and coordinate benefits. These treaties can be helpful in terms of determining first taxing authority and reducing double taxation.
However, properly interpreting these treaties and correctly applying their provisions requires training and experience. Treaties do not eliminate all complications that can result in double taxation.
It is important to note that the U.S./UK income tax treaty, like all U.S. income tax treaties, contains what is known as a ‘Savings Clause.’ By this clause, the United States in particular, saves to itself the right to tax U.S. citizens and residents as if the treaty provisions had not come into force. There are a few important treaty provisions that are excluded from the Savings Clause.
One of the benefits of the treaty is the recognition of certain account types. U.S. retirement accounts (IRAs, Roth IRAs, 401k plans) are recognized as pension arrangements by the UK. Similarly, UK employer pension schemes and UK Self-Invested Personal Pensions (SIPPs) are recognized as retirement accounts (but not U.S. retirement accounts) by the U.S.
This recognition essentially means that the tax deferral available in each country is respected by the other country. These retirement accounts are called ‘opaque,’ meaning that any income or gain inside the account is ignored. Only distributions from the account are considered potentially taxable.
The treaty recognition of Roth accounts provides, if managed correctly, an opportunity to reduce future taxation through the judicious use of so called “Roth conversions” as distributions from Roth IRAs are not subject to tax in the UK. Read more on U.S. expat IRAs and Roth IRA conversions or watch our video on the four questions for U.S. expats investing in IRAs and Roth IRAs.
However, this account type recognition does not extend to U.S. 529 Plans (or other U.S. educational saving accounts) nor to UK Individual Savings Accounts (ISAs). The tax deferral provided in one tax system is not provided in the other. This can lead to a worse outcome than holding assets in a regular taxable brokerage account.
4. Understanding pension account differences
There are important differences between U.S. and the UK retirement savings systems. There are different limitations placed on both the annual amount that can be contributed to pension schemes, and the lifetime value allowed for “pension pots,” as they are called in the UK.
You may be familiar with U.S. contribution limits such as $6,000 ($7,000 over 50) per year to an IRA or $20,500 ($27,000 over 50) for a 401k. By contrast, in the UK, the annual allowance is £40,000. However, the more you earn, the less you can contribute. Starting at £240,000, your allowance is reduced by £1 for every £2 you earn. The continues until your annual contribution allowance has been reduced to only £4,000.
In the U.S., if you have saved diligently and invested prudently it can be worth several millions of dollars and there is no limit on the value of your retirement plan. In the UK, your Lifetime Allowance is currently £1,073,100. You’ll pay tax if your pension pots exceed this amount when a ‘benefit crystallization event’ occurs (turning 75 is an example of a benefit crystallization event).
5. Taxation: Arising Basis vs. Remittance Basis
The UK has a special regime that attracts people to make the UK their base. For those who qualify, it is possible to be taxed only on UK-sourced income and earn income and gains outside of the UK free of UK tax, until such funds are remitted to the UK. This is called the “Remittance Basis” of taxation.
Many things constitute a remittance. Here are some examples:
- Using a U.S. credit card to buy something in the UK is a remittance;
- Settling a debt for a service provided in the UK by paying for it outside of the UK is a remittance (i.e. buying a ticket for a flight originating in the UK while in the U.S. using a U.S. bank account);
- Borrowing money abroad and repaying the loan using funds held abroad might be a remittance;
- And of course, transferring money earned, during the time period in which you were resident in the UK, to the UK, even if you earned the funds for working outside the UK, is a remittance.
Remittance can seem like a great benefit. And it can be, if your situation is similar to the following:
- You receive your income outside the UK and bring in only what you need to cover your UK expenses;
- You regularly work outside the UK (income from such days are only taxable if remitted);
- You have significant income from sources outside the UK such as your investment portfolio; and
- You do not expect to stay in the UK long enough to ever need to bring those funds to the UK.
The other option is known as the “Arising Basis.” Under arising basis taxation, you pay UK income tax on your worldwide income and gains as they arise. Why could that be better than the remittance basis? To make the remittance basis work, you need to keep very detailed records of all income earned and not remitted, so that you can calculate the tax liability on any income you remit. If you don’t keep such records contemporaneously, you will have to pay an accountant to determine the tax liability of any amount you remit in the future. This can get expensive.
More importantly, you will pay tax to the U.S. on the equivalent of an arising basis. If you are on the arising basis in the UK, you will be able to offset the UK foreign taxes paid on that income with foreign tax credits. If you are on the remittance basis, the tax you pay to the UK (when the income is remitted to the UK) may be years after you have paid the U.S. tax, possibly resulting in a mismatch and double taxation.
6. Considerations for estate/inheritance tax planning
This is a very complicated topic from a cross-border perspective, so we’ll only touch on the significant differences encountered by an American in the UK. [Watch a short explainer video of how we define ‘cross-border’. ]
The U.S./ UK Estate and Gift Tax Convention (the treaty which covers U.S. Estate and Gift tax as well as UK Inheritance tax) is a generous and comprehensive treaty. It leaves in place each country’s taxation rights with respect to its own nationals/citizens/domiciliaries but alleviates most of the ‘other’ countries taxation of those estates. What do I mean? If you are a UK national (and not also a U.S. national) with investments in the U.S. (other than a business or real estate) you’ll only need to worry about UK Inheritance Tax (IHT). Similarly, if you are a U.S. resident/citizen (and not also a UK domiciliary) you only have to worry about UK IHT for UK businesses and real estate.
That sounds great but it really doesn’t help a U.S. citizen domiciled in the UK. That person (our typical UK resident client) is subject to all the rules for a UK domiciliary and all of the rules applicable to a U.S. citizen.
U.S. citizens are subject to U.S. Federal Estate and Gift Tax rules on all their worldwide assets. However, in 2022, the first $12,060,000 is excluded from estate or gift tax.
The UK Inheritance Tax regime isn’t as generous. In the UK Inheritance Tax is payable by estates worth more than £325,000 (2022-2023 tax year). There are many ways to improve the outcome for a UK domiciliary, but the important point is that if your estate has a tax liability, it will predominantly be a UK IHT liability.
There are strategies that can be implemented before you move to the UK, but most people don’t have the excess wealth needed to avail themselves of those strategies. We help our clients review their options before they move.
Gifts are treated differently in the UK, with the main difference being that if you survive your gift by seven years, then it is not included in your estate. By contrast a gift, above the current annual allowance ($16,000 for 2022) is reported on a gift tax return and, if no gift tax is paid, the amount of your U.S. lifetime exemption is permanently reduced. Again, it’s about finding ways to address you future UK IHT liability that will be of paramount concern, not your potential U.S. estate tax liability.
Learn more about inheriting from the U.S. while living abroad, with a breakdown of many inheritance tax rules that apply to inheriting Americans living abroad.
7. Using trusts and wills
The UK is the origin of the trust concept. Trust professionals will tell you that during the times of The Crusades when English lords went on military campaigns to the Middle East, they realized that there was a significant risk that they might not return. Hence, this began the practice of establishing trusts, whereby their lands were held by someone else (a trustee). Trustees were required to maintain their estates and ultimately pass them to their heir in the event that they did not return.
This trust concept existed for centuries before it was codified in both trust legislation and most importantly, in tax codes. In the U.S., it is common for trusts to be established as part of an estate plan. Trusts can achieve many benefits, such as privacy, ease of administration, avoidance of probate proceedings, bringing forward estate tax realization through the application of gifting strategies (pay less gift tax now than estate tax in the future), sheltering assets from creditors, providing for special needs family members, and many other purposes. Historically, the U.S. has been a very trust-friendly jurisdiction with extensive provisions that benefit trusts established in the U.S. tax code.
By contrast, the UK has evolved to be a somewhat unfriendly jurisdiction for what are known as substantive trusts which may be subject to periodic ‘charges to inheritance tax’ (a need to pay a certain proportion of their assets as inheritance taxes even through no inheritance has actually been received). This and other complex anti-deferral rules have made the UK tax-unfriendly for trusts.
When you move permanently from the U.S. to the UK, you’ll need to seriously consider whether your U.S. estate plan still works in the UK. Most likely, you will need to revoke your U.S. will and potentially your U.S. living trust in favor of an English will that covers your worldwide assets. Watch a quick explainer video about a dual U.S./UK citizen that tackles this exact topic.
The UK is a great place to live and an exciting place from which to explore the world, but it has very complex investing, tax, and estate planning rules for American expats which you will need to navigate with care. Request a meeting with a wealth manager from Creative Planning International to discuss how we can take care of your wealth, so that you can enjoy all the UK has to offer.