UK ISAs and US tax: why an ISA is not tax-free for Americans

An ISA is one of the best savings wrappers in the UK. For a US citizen or green card holder it is a UK tax shelter with a US tax bill attached, and often a reporting burden out of proportion to the money inside it.

What an ISA is

A UK resident can put up to £20,000 a year into ISAs: cash, stocks and shares, lifetime (with a 25% government bonus up to £4,000 of contributions) and innovative finance. Interest, dividends and gains inside the wrapper are free of UK tax.

Why the US taxes it anyway

The US taxes its citizens on worldwide income and does not recognise the ISA as anything but an ordinary account. The treaty's reliefs for pensions do not extend to ISAs. So every year:

• interest in a cash ISA is ordinary income on Form 1040;
• dividends in a stocks-and-shares ISA are dividend income (qualified or not, depending on the payer);
• gains realised inside the ISA are capital gains;
• the lifetime ISA bonus is, on the usual analysis, taxable income in the US.

Because no UK tax was paid on any of it, there is no Foreign Tax Credit to offset the US tax. That is the real cost: the UK exemption buys nothing against the US bill.

The PFIC problem

Most UK-domiciled funds, unit trusts, OEICs and London-listed ETFs are passive foreign investment companies. Under the default rules, gains and "excess distributions" are taxed at the highest ordinary rate for each year of the holding period with an interest charge, and each fund needs its own Form 8621 every year. A return that omits a required Form 8621 is incomplete and the statute of limitations does not run for that year. A modest ISA holding five UK funds means five Forms 8621.

A mark-to-market or QEF election can improve the outcome but generally has to be made in the first year, and QEF needs information most UK funds do not publish.

Cash ISAs

No PFIC issue, but the interest is fully US-taxable with no credit, the account counts towards the FBAR threshold and, if the thresholds are met, appears on Form 8938.

Should a US person hold an ISA?

A cash ISA can still make sense where the UK saving matters and the US marginal rate on the interest is low. A stocks-and-shares ISA holding UK funds rarely does; the compliance cost usually exceeds the benefit. US persons in the UK more often hold US-listed ETFs in a general or US brokerage account, or use a pension that qualifies for treaty treatment.

We do not give investment advice; the tax consequences above are the point of this article, and the decision is yours or your financial adviser's.

Existing ISA holders

If past US returns ignored the ISA, the fix depends on what was missed: amended returns, Form 8621 catch-up, or the Streamlined procedures if returns and FBARs were also missed. Doing it before the IRS writes is much better than after.

Frequently asked questions

Do I report my ISA on the FBAR?

Yes, if your combined non-US accounts exceeded US$10,000 at any time in the year. An ISA is a foreign financial account.

Does Net Investment Income Tax apply to ISA income?

It can, at 3.8%, once modified adjusted gross income exceeds US$200,000 (single) or US$250,000 (joint). Foreign tax cannot be credited against NIIT.

I stopped paying in. Does the problem go away?

No. Income and gains on the existing balance remain reportable until the account is closed.

I inherited an ISA. What now?

A surviving spouse can inherit the ISA allowance in the UK, but for US purposes the account is simply yours from the date of inheritance, with all the reporting above.