US Roth IRA (Account Options)

Number 2 in the series on account options – full list is at Account Options.

Edit 07Jul21: I’ve changed my view on whether Roth IRAs need to be opened before leaving the US – I no longer think that’s a requirement, although it’s logistically easier. I’ve updated the post to reflect that.

Edit 13Aug21: There are some people who are pretty convinced that Roth IRAs do need to be opened before leaving the US, although I’m not convinced. I’ve added a recognition of that point for completeness, and added my rationale for why I think this is an overly conservative interpretation.

Synopsis

As long as you’re eligible, this is a great option with tax benefits in both countries and no tax-related limits on what you can invest in.

Priority

Filling your annual Roth IRA allowance should come right after maxing out the employer match in your UK employer pension – or maybe after maxing out the employer pension as a whole, kind of a tossup there, depending on the options and fees in the pension.

There’s an argument for considering a Traditional IRA instead of a Roth, if you can deduct your Traditional contributions on your UK taxes. That’s theoretically possible (albeit subject to some treaty interpretation), so long as you meet the eligibility requirements, but whether you want to jump through the hoops to do it is up to you

Eligibility

You must have earned income to contribute to a Roth IRA. Not gifts, not interest, not capital gains, not unemployment, not welfare, not stimulus payments – earned income. But the good news is that foreign earned income is completely fine, as long as you haven’t excluded it using the Foreign Earned Income Exclusion (FEIE). For most Americans in the UK, the Foreign Tax Credit (FTC) is more beneficial anyway – I’ll post more on that in the future.

There are income limits as well – for 2021, the amount you’re allowed to contribute starts to phase out at $125k (single filing), $198k (married filing jointly), and a very low $10k (married filing separately). For those people with a non-US spouse they want to keep out of the US tax system, that’s a big drawback.

If you’re above the income thresholds, there is a completely legitimate loophole, called the Backdoor Roth. I’ll post more on that in the future, but the short version is that you make a non-deductible contribution to a Traditional IRA and then immediately convert it to a Roth IRA. There’s no income limit this way, and it’s just a little bit more paperwork/mouse clicks.

The big challenge is that you may find it challenging to manage an account without a US address. Many people use a US address (a friend, family member, etc.) – that’s not ideal, since they’ll get your mail and might get sick of it, and it’s of somewhat dubious legitimacy. This is something I’d like to do some more research on and find a good way around. For the moment, Charles Schwab and Interactive Brokers are known to work with people, and I’ve seen some mixed reports as to whether Vanguard won’t freeze your account if you’re already an established customer. Worst case, you won’t lose your money, but you might get your account shut down and only have 60 days to find another IRA provider or get hit with some ugly US taxes on an early distribution.

One more caveat – I have seen some interpretations that even if a Roth IRA is already open, once you move to the UK any new contributions are not tax advantaged in the UK. This seems to be an unusual interpretation, possibly based on a clause in the US/Canada tax treaty (Article XVIII Paragraph 3b from the 2007 protocol, if you’re interested). That treaty is pretty clear, but there’s no similar language in the US/UK tax treaty. There’s obviously major drawbacks if this interpretation is true, and if you have any doubts, you should seek professional advice. For my own personal situation, I’m confident that this is an overly restrictive interpretation.

Edit 13Aug21: There are some people of the opinion that only a Roth IRA that was already open prior to moving to the UK is treated as a tax-advantaged account by HMRC. I think this is an overly conservative interpretation of the treaty, but figured I should call it out for completeness. I’ve added a section at the bottom of this post as to why I don’t think this is the case. That said, I do recommend that you open both Traditional and Roth IRAs before leaving the US – even with just a nominal sum, it avoids any worries about this. It matters more for Traditional IRAs, due to the contribution question.

Investment Options

From a tax perspective, you can invest in whatever you like. It’s pretty clear that you can hold funds that don’t report to HMRC without any problem (although if you want to be extra safe, it’s not hard to have a good three or four fund portfolio using only HMRC reporting funds). You probably shouldn’t hold PFICs here, but there’s no real reason why you would want to when you can buy US-based funds anyway.

That makes a Roth IRA the perfect place for any weird, high-risk investments – YOLO on GME! If you make 1000x returns, it’s still tax free.

Big Caveat: There’s some lovely EU, and now UK, legislation called MiFID and PRIIP that requires funds to issue a Key Information Document (KID) to prospective investors. There are no US funds that I’m aware that issue such a document – supposedly, they’re caught in a Catch-22 around US vs EU/UK reporting requirements. If the fund doesn’t issue that document, the broker shouldn’t sell the funds to retail investors living in the UK/EU like you and me. A few ways around this:

• Keep using a US address on your Roth IRA (although maybe a little dubious!)
• Don’t be a retail investor – you’ll need a large portfolio (€500k+) and/or be a finance professional
• Invest in individual stocks only, same solution as getting around PFIC, I’ll post more on how to do this later
• Use options and actually exercise them (I added this option on 07Jul21 – I’m going to explore it some more to see how feasible it is, but it’s been mentioned other places and worth at least thinking about. Edit 13Aug21: I’ve explained this option more in this post, plus a new one below.
• Invest in EU (probably Irish) ETFs in your US Roth IRA. The IRA wrapper means PFIC concerns don’t apply, and there’s a broad selection to choose from.
• Have an advisor invest for you – but you’ll pay them, of course

Risk & Return

Entirely depends what you invest in – capital at risk, no guarantees

Withdrawal Options

One nice thing about the Roth IRA is that you can access your contributions at any time, with no penalty. Of course you have to sell any investments, but as long as you don’t take out more than you’ve contributed, there’s no tax or penalties. Certainly not the first place for your emergency fund, but a better option than most investments.

For earnings, you can withdraw them at 59 1/2 or older, as long as you’ve held the account for 5 years. There are no taxes or penalties on withdrawal.

If you want to withdraw earnings before 59 1/2, you’ll pay tax on the gains plus penalties. There are some exceptions for first-time home purchases, education, medical expenses, disability, death, etc. You’d also want to check into UK tax implications – this gets a bit complicated, and ideally you want to avoid it anyway!

Contribution Limit

For 2021, you can contribute $6,000 per year, per person ($7,000 if you’re over age 50). This goes up with time. The contribution limit is shared with any Traditional IRAs. The UK doesn’t impose any additional limits over what the US does.

Fees

These will depend on the provider, but having the account open should be free or nearly free. Fees on the underlying investments will vary, but if you’re using index funds these should be low, usually under 0.1%.

UK Tax Treatment – Contributions

Roth IRA contributions always come from after-tax money, so there’s no tax impacts at the time of contributing.

UK Tax Treatment – Withdrawals

The UK recognizes the US tax advantages, so there is no tax on withdrawing contributions at any time, or on earnings after 59 1/2. Early withdrawals that are subject to US tax and penalties get complicated – try not to do this!

US Tax Treatment – Contributions

Same as with the UK, contributions are from after-tax money, so there’s no impact.

US Tax Treatment – Withdrawals

As long as you’re 59 1/2 and have had the account for 5 years, there’s no tax on your withdrawals of earnings. Contributions can be withdrawn tax and penalty free at any time.

Roth Conversions

I’ll write a focused post on this in the future, but the quick version is that you can convert a Traditional IRA (including any rollovers from a 401(k) or similar) to a Roth IRA, and then that money will be tax-free on withdrawal after age 59 1/2. This is a taxable event in the US – you’re taking tax-deferred money and moving it to an after-tax account, so the IRS wants to get paid.

The good news is that this is very probably not a taxable event in the UK. So you can take money that you didn’t pay UK income tax on when you earned it (mostly because you didn’t live in the UK yet), and convert it so you don’t pay UK tax when you withdraw it, and not pay UK taxes in the process. Caveat is that there are a few different treaty interpretations, but this seems to be the prevailing one. You might also be able to use excess foreign tax credits to offset the US tax due – this gets a bit complicated and I’ll explore it more later, but it could be a very significant advantage.

Does an IRA need to be open before moving to the UK?

Usual disclaimer: I am not a lawyer, and this is bordering on legal interpretation of the treaty. Seek professional advice if this is important to you.

Some people argue that a Roth IRA is only treated as a tax-advantaged “pension” if it was opened prior to moving to the UK. I think this is a flawed interpretation of the US/UK tax treaty:

• Article 18 deals with pension contributions, and says that contributions to a pension in the other country (in this case, a US IRA) can only be treated as tax advantaged if the pension was established prior to moving to the first country (the UK).
  • This is the clause that raises the question as to whether Traditional IRA contributions can be deducted on UK taxes if the tIRA is opened after moving to the UK – I think it’s pretty clear that the answer is “no” (there’s a different question as to whether they’re UK deductible at all, but that’s not the question at hand).
  • But the deductibility of contributions isn’t the question here – nobody thinks that they can deduct Roth IRA contributions, from US or UK taxes. That’s the whole point of a Roth account – after-tax money going in, no more taxes ever again.
• Article 17 deals with pension earnings and distributions. There’s nothing in this article dealing with accounts that were or weren’t opened in the country of current residence, it’s just not a topic. It does make it clear that any payments from a US pension that would be tax-free in the US are also tax free in the UK – so because a Roth IRA is US tax free on withdrawal, it’s also UK tax free.
• That’s really it – there’s nothing in the treaty dealing with the topic at all, and I haven’t found anything in UK law or regulation, either.
  • HMRC’s double taxation manual doesn’t have anything to say about it
  • The US technical explanation of the treaty makes it clear that the limit requiring pensions to be opened before moving only applies within Article 18 – to contributions (note that the US interpretation isn’t binding on the UK, but hopefully indicates that some people very familiar with the treaty have this interpretation).

If anybody has an alternative argument, I’d be very open to hearing it and will happily update this post with the counter-argument in the name of openness (and will change my opinion if it’s convincing!).

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