ISAs are a really interesting kind of account – there’s nothing even close to them in the US, where you can invest, allow your investments to grow tax-deferred, and then withdraw them whenever you want. Sadly, that means the IRS doesn’t recognize them as anything special – but I think they still have a place in the FIRE arsenal for Americans in the UK. They come in a few different flavors, but the Stocks & Shares (S&S) ISA is the best fit for long-term investing.
Strong UK tax advantages, but you’ll need to manage a portfolio of individual stocks to avoid PFICs. To the IRS, it’s just a taxable brokerage account, but that’s not so bad.
After UK pensions and US IRA – those both have tax advantages in the US and the UK, now we’re getting into accounts with only limited tax advantages.
Skip S&S ISAs if you aren’t comfortable with individual stocks.
You might pick a Lifetime ISA first over a S&S ISA – you get a 25% bonus from the government, but the money is locked up until age 60 except for a first home purchase.
All UK residents over age 18 – there are also slightly different children’s ISAs.
Many UK brokers won’t work with US citizens. The one I know for sure is Hargreaves Lansdown, since I have my S&S ISA with them. If you know of others, please put them in the comments and I’ll start to compile a list.
You can hold almost anything you want in a S&S ISA – mutual funds, ETFs, etc. However, unless you want to deal with the IRS’s painful and punitive treatment of PFICs, you’ll want to avoid them here.
- I’ll do a longer post on PFICs in the future, the quick and dirty is that essentially all non-US mutual funds and ETFs are considered PFICs.
- PFICs require labor-intensive reporting as part of your tax return, and have negative tax consequences.
- There are options to reduce, but not eliminate, the pain – that’s fairly advanced, though. To me, it’s interesting, but not worth the hassle.
Therefore, if you want to avoid PFICs, you’re mostly looking at stocks in individual companies. These could be in the US, the UK, or anywhere you like. Individual bonds are fine too, although make sure you’ll get the information you need from the UK broker to complete your US tax returns, just in terms of recordkeeping. Personally, I’m keeping bonds to a bond fun in my IRA, and leaving my S&S ISA with just stocks.
This is not the place for high risk/high return shares. If you get a 100x return, the UK won’t tax you but the US will. Instead, this is a great place for big, boring companies, probably as a sort of pseudo-index.
- I’ll do a more detailed post eventually, but my approach has been to pick 20 of the largest companies in the FTSE 100 and hold them in roughly equal value. It’s simple, and my rough backtesting indicates it’ll approximate the overall return of the FTSE 100. I chose UK-only just because my broker charges additional foreign currency fees and I can hold non-UK funds in other accounts, so I’ll just avoid that extra cost.
Risk & Return
Depends on the investments you choose. In general, individual stocks are a higher risk than a diversified index fund. Fully replicating an index is possible, but cost prohibitive due to the number of transactions – at a typical £10 per trade, you’d spend £1,000 to buy the whole FTSE 100 or £5,000 for the S&P 500, and the same again to sell it.
This is where ISAs are massively different from a pension or IRA – you can withdraw all of your contributions and earnings at any time. No penalties, no UK tax.
US tax will be due on any capital gains and dividends as they occur, whether that’s through a withdrawal or transactions within the account.
£20,000 per year per person (2021), shared with all other ISAs. The year is the UK tax year (06 April to 05 April).
If your ISA is “flexible”, you can contribute, then withdraw, and then replace it in the same year without counting against your annual limit. If it’s not “flexible” (many aren’t), both contributions count. Quick example:
- Flexible: You deposit £20,000 in your ISA. You need £10,000 and withdraw it. Later in the year, you replace the £10,000, leaving £20,000 (plus any gains/minus any losses) to grow from there. You can contribute another £20,000 next year.
- Not Flexible: You deposit £20,000 in your ISA. You need £10,000 and withdraw it. Later in the year, you have the £10,000, but you aren’t allowed to replace it, leaving £10,000 (plus any gains/minus any losses) to grow from there. You can contribute that £10,000 next year, plus another £10,000 for the total £20,000 limit.
Three main ways you get charged:
- An annual platform fee. This might be a flat rate, a percentage, or a capped percentage. Huge variations, and what’s best for you will depend on how big your ISA is.
- Dealing fees (what an American might call a transaction fee). This is a charge per trade. Many brokers don’t charge fees for dealing in funds, but since you probably want individual stocks, you’ll be paying these. They vary somewhat, and some brokers offer lower rates if you trade more often – that’s probably not what you want to be doing if you’re trying to emulate an index fund, though! These can add up quick – £10 or so a trade is typical. There’s also sometimes a discount for recurring transactions via direct debit, instead of on-demand trades.
- Fees on the underlying assets – if these are just individual shares, there’s nothing. If you’re investing in mutual funds/ETFs, there will be.
UK Tax Treatment – Contributions
All ISA contributions are from after-tax money, there is no tax impact.
UK Tax Treatment – Withdrawals
Withdrawals of both contributions and earnings are tax free. No income tax, no capital gains tax, no tax on dividends or interest.
US Tax Treatment – Contributions
The US treats this like a taxable brokerage account, so all contributions are made with after-tax money, no tax impact.
US Tax Treatment – Withdrawals
Since the US treats a S&S ISA like a taxable brokerage account, you’re liable for tax on all the same sorts of transactions. Capital gains when you realize them, interest and dividends when they’re paid, etc. This applies even if you don’t take the money out of the account and reinvest it.
This does include the distinction between short vs long term capital gains and qualified vs ordinary dividends. In short, it’s more tax efficient to save for the long term and avoid holding investments for only short periods. That also saves you on dealing fees, so good all around.
There may be options for tax loss harvesting – realizing a capital loss in order to offset capital gains.
Monevator list of ISA providers – sadly, most of these won’t work with US citizens