Picture a street of rainbow-coloured houses. On one side of the road is a British tax inspector with one rulebook; on the other side of the street an American tax inspector with another rulebook. Each house in the street represents an investment product or ‘tax wrapper’. Each tax inspector’s has different rules so looks at each house differently. Each house is assessed differently, what’s inside each house – how it’s taxed – is different whether its the UK and US taxmen looking in.
Let’s see how they’d approach the assessment of each different coloured houses.
Thinking of tax wrappers as houses make visualising how different tax rules apply easier. If you need financial advice on navigating the UK and US tax systems, professional guidance can be invaluable in maximising the advantages of each side of the street!
Hector the Tax Inspector
A bowler-hatted tax inspector named ‘Hector the Tax Inspector’ stood as the British archetype in a series of adverts from the 1990s published by the UK tax authority, Her Majesty’s Revenue and Customs. The character was used to encourage people to file their tax returns on time and pay their taxes correctly. Hector became a well-known figure during that era, representing the taxman in the UK.
The UK Tax Inspector’s View
Hector, the Tax Inspector in Britain, thinks of tax wrappers in terms of capital gains and income tax. Basically, it is about taxing your savings and investments, like your ISAs and pensions.
The ISA House
Tax View: Tax-Free Haven
UK Context: This house is an ISA (Individual Savings Account). Whatever wealth (stocks, cash or bonds) you hold inside this house, it can grow without capital gains or income tax from the HMRC. From the moment you invest your savings here, they are not for anything done inside the house and if if you don’t move out of the house the gains and income are withdrawn tax free in the UK. However, Non-Reporting Funds (offshore funds not registered with HMRC) can complicate things for UK taxpayers, as gains from these are taxed as income rather than capital gains, even when held in an ISA.
Tax Treatment of Income: No tax on interest or dividends in the ISA.
Taxation on Capital Gains: There is no capital gains tax payable on the gains generated inside the ISA or when cash is moved out of the ISA.
The UK Pension House
Tax View: Ringfenced until old age.
UK Setting: Pensions in the UK, corporate or private, are more nuanced. Hector isn’t taxing the money you give to this house immediately. But when the house reaches an age and pays out, he will start collecting income tax. All withdrawals are taxable income, but 25% can be withdrawn as tax-free cash. A workplace pension is the 401k UK equivalent.
Tax Rates on Income: Withdrawals are considered income (except the 25% tax-free lump sum).
Capital Gains Taxes: Gains inside the pension increase without paying tax until you start taking money out.
The General Investment Account (GIA) House
Tax View: Taxable with Special Rules for Non-Reporting Funds
UK Context: A General Investment Account (GIA) offers fewer tax benefits, as any income or capital gains within this account are taxed annually. However, Non-Reporting Funds pose a particular challenge here. Gains from Non-Reporting Funds are not treated as capital gains but instead as income, which is typically taxed at a higher rate.
How Income is Taxed: Dividends and interest are taxed annually.
The US Tax Inspector’s View
The American tax inspector at the other end of the street looks at the houses differently. And it’s also about income and capital gains tax in the US, through the lens of tax-deferred vs. tax-free growth in things such as IRAs and 401(k) plans.
The Traditional IRA House
Tax View: Deferred Until Retirement
US History: To the US inspector, a Traditional IRA (Individual Retirement Account) is the UK pension house. You can pay in taxes if you buy the house but Uncle Sam will come calling once you start drawing down in retirement. They are taxed as ordinary income when you withdraw the money, and growth in the IRA isn’t taxed until then. Fortunately for US investors, PFICs held within IRAs are generally not subject to punitive PFIC rules, as IRAs are shielded from certain reporting requirements. However, this benefit is limited to qualified retirement accounts like IRAs and 401(k)s.
Taxes On Income: Taxed on cash out as regular income.
Tax Rates for Capital Gains: No tax due at the time of withdrawal.
The Roth IRA House
Tax View: Tax-Free Growth Forever.
The US Perspective: The Roth IRA is an outlier in the US tax code. The inspector knows that payments are taxed up front, but once in the bank growth and later withdrawals are tax free. For the US tax collector, this house is a home from which both income and capital gains tax are exempt.
What is the Taxation on The Income: There is no Tax on withdrawal.
Tax Treatment of Capital Gains: There is no capital gains tax on investments in the Roth IRA.
The 401(k) House
Tax Perspective: Invested like an IRA. Deferred Like An IRA.
US Overview: Just like the Traditional IRA, the 401(k) is a tax-deferred retirement plan. Contributions lower your income today, but withdrawals in retirement get treated as ordinary income. You can also get growth inside the 401(k) deferred, which is to say you don’t pay tax until you withdraw the money.
Taxation on Income: Taxed like other income in retirement.
Taxation on Capital Gains: None inside the wrapper its just taxed as you take proceeds that are considered income.
PFICs and Non-Reporting Funds: What are they?
PFICs and Non-Reporting Funds are similar: they are non-compliant investment vehicles from the tax inspectors’ perspective, so they are punitively taxed. Potential benefit for income and growth taxes can be lost by holding these assets. They can also severely hinder UK/US holders as a result in complicated reporting requirements. Let’s explain them country-by-country:
PFICs (Passive Foreign Investment Companies)
- US view: Non-US mutual funds, ETFs, some foreign passive income companies are PFICs. They are taxed to discourage US investors from investing outside of transparent US based investment vehicles. Income from PFICs is treated as regular income but deferred gains carry an interest surcharge.
- UK Consequences: If you live in the UK and have US investments, PFICs don’t generally attract special UK taxation due to their PFIC status its the non-reporting fund implications that are important from the UK perspective.
Non-Reporting Funds
- UK View: Non-Reporting Funds are offshore funds that don’t send HMRC the income and gains (so generally will end up in the tax bracket of income instead of capital gains). Non-Reporting Funds can influence ISA tax treatment and are avoided in UK pensions as they are tax inefficient.
- US Impact: Non-Reporting Funds can be seen as being the same type of fund as PFICs by US tax inspectors, and so may raise double taxation problems for UK people with US assets.
Houses viewed differently by US and UK tax authorities
Visualizing how different tax rules operate is easier if you imagine tax wrappers as houses. If you want some guidance on the UK and US taxation regime, professional advice can be life-saving if you want to get the most out of both sides of the street!
The UK and US tax inspectors look at the same road of money but they rate the houses differently. If you live with one foot in both worlds, you better prepare yourself. Reading up on tax treaties and how to guides is good idea but to make the most of akk theses houses’ for life as a dual citizen a helping hand can be helpful. Whether getting a ISA house, UK pension, IRA or 401(k), learning the differences is key to being on the right side of the tax man (whichever side of the road you find yourself).
Cross-Border Financial Planning
If you’re a dual citizen or expatriate navigating the streets of both the UK and the US, you may own houses on both sides of the street. In such cases, understanding how each tax authority views these houses is critical to optimising your savings and minimising your tax burden. The rules of what you can hold and in what wrappers is important.
For example:
- ISAs might be tax-free in the UK, but the US tax inspector doesn’t see them that way. To him, the growth and income inside an ISA could be subject to tax. There are also rules to ensure the right assets are held in the house, the UK Authorities have
- US retirement accounts like IRAs or 401(k)s have special tax advantages in the US, but may not enjoy the same benefits under UK tax law.
Managing your investment houses is more than managing finances. Beyond the immediate, there can be a great deal more to the world of money, with tax brackets changing, retirement plans developing, and opportunities for investments taking place well into the future. That’s where a financial adviser comes in: an insider, with “binoculars” on the horizon, seeing ahead and planning for you. Day-to-day finances, you can take care of it, but the financial advisor brings experience and savvy to safeguard your long-term ambitions, so every move today is aligned with a future that mapped out to help you get there.