Intro to US & UK Inheritance Taxes

Cross-border estate and gift tax planning is extremely complex. The intent of this post is really to give you some background information so that you can walk into a meeting with an estate planning professional knowing the basics of the systems, not to give you enough knowledge to do it yourself!

Estate planning is not something I do independently, especially when I’m considering two countries, kids, etc. But, I find it’s a lot better use of time (and thus money) to have a conversation with a professional when you already know the basics of how the systems work, familiar with the vocabulary, maybe know some of the common pain points, etc.

Quick note on terminology: the US calls this tax an estate tax, the UK an inheritance tax. Some people like to sensationalize them as a “death tax”. It’s all the same general idea – when you die, your estate may need to pay some taxes prior to passing your assets to your heirs. I’ll generically refer to them as “inheritance taxes”, unless I’m talking specifically about the US “estate tax.”

Both countries also have a gift tax, which is for gifts you give before your death – basically making sure you don’t decide to just give everything away before you die and get out of paying inheritance taxes.

When do I need to worry about inheritance taxes?

As a US citizen living in the UK, there’s three main thresholds where inheritance taxes become a concern:

  • If your estate is over £325,000, you should be planning for UK inheritance taxes. That probably applies to most readers here. There are ways of raising that threshold, which we’ll talk about later, but that’s the point where you need to start thinking about it.
  • If your estate is over about $11.7 million (single) or $23.4 million (married), you need to plan for US inheritance taxes. You should definitely seek professional help from somebody who understands how both systems work and interact with each other – this post might help with some background, but at that level you absolutely should get professional advice. Also, if your non-US citizen spouse has more than $60,000 in US assets, inheritance tax can apply to them.
    • There is discussion of lowering this exemption to something more like $5 million or lower.
  • If you’re giving gifts above £3,000 per year (in total, not per person), you’ll also want to be aware of the UK gift tax rules. Above $15,000 per year per person, and you’ll also need to consider US gift tax reporting. In both cases, you’re unlikely to need to pay anything, but should be familiar with the requirements.

Quick Note – Receiving Gifts & Inheritances

Don’t stress about receiving inheritances, whether from the US or the UK. Any taxes due will be paid by the estate, not by you.

Mostly the same story with gifts – these are generally not taxable, and if they are taxable, the giver almost always pays the tax. Two exceptions to be aware of:

  • For the UK, if you receive a gift above the typical £3,000 annual exemption from a UK taxpayer and the giver dies within 7 years, you may need to pay a portion of the inheritance tax.
  • For the US, there’s a possible election to have the receiver pay, instead of the giver. Talk to a professional if you consider taking this option.

The US/UK Estate Tax Treaty of 1979

I am not going to go through this in detail, like I did with the income tax treaty – it’s probably enough to just know a few high level concepts. These are just my layman’s interpretation, to give you a head start on understanding it if you need to:

  • The treaty contains rules on whether you will be treated as US or UK domiciled. For the most part, if you live in the UK permanently, you’ll be treated as UK domiciled, even if you’re a US citizen.
  • The country of domicile is the only one that gets to tax the person who dies, with the exception of Real Property (real estate, generally taxed in the country where the property physically is) and fixed Business Property (generally taxed wherever the business is permanently established) – but this doesn’t apply if you’re a citizen of the other country.
  • In our typical case, of a US citizen domiciled in the UK, both the US and UK get to tax your estate. The US must grant a credit for the UK tax paid, to avoid double taxation.
  • In practice, given that the US inheritance tax exemption is much higher than the UK (£325k vs $11.6 million), this often won’t come into play anyway.
  • If you’re above the US exemption and UK domiciled, I strongly recommend talking to a professional!

Background – UK Inheritance Tax

The UK bases inheritance tax on the deceased being domiciled in the UK – since taxes are paid by the estate of the deceased, this doesn’t apply to Americans in the UK who are inheriting from the US or a third country.

If you’ve been in the UK long term, like 15 of the prior 20 years, you’ll be deemed to have a UK domicile. Even if you’ve been in the UK a shorter time, you might have a UK domicile – determining this can get complicated. For our purposes today, let’s assume you’re UK domiciled – if you’re trying to stay US domiciled while living in the UK, your situation is complicated enough you likely want professional advice.

The UK inheritance tax has a relatively low £325,000 threshold – some quick notes on that:

  • If your estate is below £325,000, there’s no inheritance tax to pay
  • You can increase the threshold to £500,000 if you give your home to your children or grandchildren and your total estate is worth less than £2 million
  • There’s no tax if everything above £325,000 is passed to your spouse/civil partner, charity, or a community amateur sports club.
  • You can pass your home to your spouse/civil partner without incurring Inheritance Tax
  • If you don’t use all your threshold, you can pass the unused portion to your spouse/civil partner – their threshold could be up to £1 million in that case (basically, leave everything including a family house to them, then they can leave £650,000 to whoever they like and £350,000 worth of the family home to kids/grandchildren, before needing to pay tax)
  • Everything above the threshold is taxed at a standard rate of 40% – this can be reduced to 36% on some assets if 10% or more of the net value is left to charity (incentive to make charitable gifts in your will)
  • Inheritance generally resets the basis for Capital Gains tax to the the value of the asset at death – this avoids double taxation for both inheritance & capital gains
  • Pensions are generally protected from inheritance tax, although income tax will be owed by the recipient. There’s an exception if the owner dies before age 75, which usually means there will be no tax at all.
  • ISAs are not protected from inheritance tax – they will be part of your estate and taxable

Edit 07 April 2021: Reader Jeffrey Beranek pointed out there’s another potentially useful exemption: gifting from “excess income” or, in HMRC-ese, a “normal expenditure out of income”. Basically, if you give a regular (routine, periodic) gift out of your income (not assets) that is excess to what you need to maintain your standard of living, this can be exempted from inheritance tax, even if you die within 7 years. This requires that you have excess income, but the income could come from lots of places – employment, rental properties, pensions, dividends, interest, etc., anything that isn’t “capital.” More information from HMRC.

Background – US Estate Tax

US estate tax applies above about $11.7 million for an individual estate – I’ll say it again, if your estate is large enough to worry about US estate tax, you should definitely be getting professional advice!

A few quick background notes so you know a bit of what you’re getting in to:

  • Above the $11.7 million exemption, there’s a progressive tax applied, ranging from 18% to 40% (the 40% tax rate starts from about $12.6 million)
  • If your spouse is a US citizen, there’s no inheritance tax due on what you leave him/her. You can also combine lifetime allowances.
  • If your spouse is not a US citizen, there’s no special allowance for inheritance tax – if you’re over the exemption, this could be taxable even if you leave everything to your non-US spouse. However, depending how you read the US/UK Estate Tax Treaty (article 8 paragraph 2), the non-US spouse may benefit from an exemption.
    • I haven’t found anybody mentioning this treaty provision, but it’s hard to search for these kinds of details. Worth talking to a professional if you’re close to the exemption and would leave a large amount to your spouse.
  • There is a larger annual gift allowance for a non-US spouse, $159,000 in 2021 – this could be used with some advance planning, it gets complicated.
  • For non-US citizens with US property, the exemption is only $60,000 – if you have a non-US citizen spouse with US property, this could easily be you. However, the US/UK Estate Tax Treaty gives protection here – you should benefit from the same $11.7 million exemption as a person with a US domicile (article 8 paragraph 5)
  • Cost basis for capital gains is generally reset to the value upon inheritance.

Background – UK Gift Tax

The vast majority of gifts are not taxable in the UK. This includes any gifts, of any amount, given more than 7 years before your death, as well as gifts within 7 years of death that fall under certain exemptions.

Two simple rules that would avoid any taxes, then I’ll go on about the details:

  • Don’t give away more than £3,000 in a year
  • If you do give away more than £3,000 in a year, don’t die for another 7 years

There are a few higher caveats to the exemptions (weddings, living costs, gifts to charities & political parties, etc.), but typically any gifts totaling less than £3,000 per year are not taxable, regardless of when they’re given. You can carry this forward for a year, as well. In addition, you can give as many gifts up to £250 per person as you like without counting against the exemption, as long as you haven’t used an exemption with that person. For example, if you give £3,000 to person A and £200 to people B, C, and D, that’s ok, but if you give £3,000 to person A and then another £200 to person A, that extra £200 would be liable for tax if you die within 7 years.

If you give gifts over the exemption (typically £3,000) and then die within 7 years of the gift, the recipient may owe inheritance tax, depending on the value of your estate and amount of gifts you’ve given within those 7 years. This tax rate is tapered, ranging from 8% in year 6 before your death to 40% if given less than 3 years before death.

Generally, gifting resets the basis of any assets – if you give a recipient stock that has gained since purchase, the cost is reset to the value at the time of the gift.

Background – US Gift Tax

Just like the UK, the vast majority of gifts are not taxable in the US. The concept works a little differently though – there are still annual exemptions, but instead of a 7 year time horizon, there’s a lifetime exemption:

  • Gifts under $15,000 per giver, per recipient, per year are neither taxable nor reportable.
  • Gifts over the $15,000 limit start to count against your $11.7 million lifetime exemption from estate tax. You don’t have to pay tax on them as long as your lifetime gifts don’t exceed your lifetime exemption, but you do need to report them on your US taxes (Form 709).
    • If you’re planning on giving more than $11.7 million in gifts over your lifetime, definitely talk to a professional!
  • Transfers to a US citizen spouse don’t count as gifts – give as much as you want
  • Transfer from a US citizen to a non-US citizen spouse have a higher annual limit, $159,000 in 2021. Above this limit, it counts against your lifetime exemption and requires reporting on your US taxes.

Gifting typically does not reset the basis of assets – when the recipient sells the asset, they will need to report and possibly pay tax on the value based on the original price of the asset.

Further Reading

This is a very complex subject – I’ve tried to give a high-level overview above, but if you notice any areas where I’ve missed important nuances or just plain wrong, I’d be eager to hear from you (and will happily edit the post to be clear and correct). Thanks!

Gov.uk: UK Inheritance and Gift Tax

IRS: US Estate & Gift Tax

Saving & Investing for Kids

We know that 529s aren’t typically a great option for Americans in the UK, but you want to save some money for your kids – maybe for university, a first home deposit, or other long term goals, right? And maybe their grandparents want to start some kind of savings for them, too?

I’ve put together the options that I think make the most sense to explore further. Which makes the most sense will depend on the specific situation and goals, but hopefully this gets your started.

Saving or Investing?

First thing you need to decide if you’re saving or investing for you kids. Saving means that you don’t want to risk the capital, but you’ll be accepting lower interest rates – think savings accounts. Investing puts the capital at risk, in exchange for hopefully higher returns – think stocks.

Typically, you would consider investing for longer time horizons (maybe over 5 years), and saving for shorter ones, but your individual risk tolerance needs to be considered here. You can certainly do a mix, as well.

Savings Options

Interest rates tend to be pretty low on these, but a normal savings account is fine. There are specific accounts for kids, some with relatively good interest rates. Premium bonds are another good option that happen to be UK tax free.

You could look at a cash ISA (either your own, or a junior one in the child’s name), but between the low interest rates and UK tax allowances on savings, I’d rather use my ISA allowance for investing.

US savings bonds are another one that could be worth considering for long term savings – series EE bonds are guaranteed to double in value after 20 years, about a 3.5% interest rate, which is pretty good these days – if you take the money out before that, it’s a much lower rate, 0.1% as I write this. Obviously you’re locking up money for a long time at a moderate interest rate, and they’re taxable in both the US and UK, but could be a part of the solution. Sadly, you also have to deal with the archaic TreasuryDirect website…

UK savings bonds (gilts) might be worth looking at too, but don’t have the same guarantee, and interest rates are pretty low these days (writing in April 2021).

Investing Options

A few different options here – honestly, all have pros and cons, there’s no clear winner, so what is best for you will depend on exactly what you want to do:

  • Junior ISA in your kid’s name: UK tax advantaged, need to have US-friendly investments (probably individual stocks) and are US taxable. Can’t get the money out before the child turns 18 (barring death/terminal illness), and once they turn 18, the money is theirs to do with as they please. Separate £9k/year allowance from your adult ISA allowance.
  • Adult S&S ISA in your name: UK tax advantaged, need to have US-friendly investments, and are US taxable. Big advantages over the junior ISA are that you can get to the money any time, penalty-free, and you control the money – it’ll be a gift to your kid as and when you give it to them. If they’re blowing it all on partying, you can turn off the tap. Big con is that you’re using your £20k/year allowance for this, instead of your own retirement saving (only really an issue if you’re maxing out your ISA anyway)
  • Taxable brokerage: US vs UK has pros and cons (see the link). No tax advantages, but no limits on how much you can invest or when you can get the money. Be careful that what you invest in is both US and UK tax friendly (HMRC reporting, PFICs, etc.)
  • UK SIPP: As long as you are convinced a SIPP is a pension under the tax treaty, this can work for really long term investment – age 55 or 57, and that may go up further in the decades your child owns it. You could also use your own SIPP, if you’ll be at the right age when you want to give the money to your child.
  • IRA‘s require earned income, so typically don’t work for this

Gift, Inheritance, & Estate Taxes

This all gets pretty complicated (I want to put together an intro in a future post), but the good news is that for most of the kinds of gifts that most people would be giving to kids, it’s not a big deal.

For gifts from US taxpayers, there’s an annual exclusion of $15,000 per recipient, per giver. If you do go over this, it will start to count against the $11 milllion+ lifetime exemption. Only once you exceed that do you need to worry about tax – if anybody involved has an estate approaching $11 million, seek professional advice!

For gifts from UK taxpayers, the system is a little different. There’s an annual exemption of £3,000 per recipient, per giver, and anything above this limit counts as part of the givers estate (there are a few other exemptions, the UK government has a good quick intro). But as long as the giver doesn’t die in the 7 years after the gift, there’s no tax due. If they do die within 7 years, it’s a tapered calculation, and depending on the overall size of their estate, there may be taxes due. Keep gifts under £3k a year or stay alive for 7 more years, and there’s nothing to worry about!

In both countries, gift and inheritance taxes are paid by the givers, not the recipients (with an exception in the UK, if you receive a gift and the giver dies within 7 years of giving it). Typically, there’s nothing required at all by the recipients, and no taxes payable.

What am I doing?

Not that you should necessarily copy me, but here’s my current thinking:

  • All my current savings for my daughters is in a US taxable brokerage account – this is the proceeds from closing the 529 it used to be in, which happened to be a the same provider. Not an entirely deliberate decision, but a perfectly reasonable place for now.
  • Depending how my S&S ISA experiment goes, I’ll consider ISAs for the girls as well, whether in mine or in a junior ISA. They’re too young for now to have any guess as to how mature they will be at 18, so I’m hesitant to do a junior ISA.
  • In the future, I’ll also open child savings accounts for them, and probably use them as a component of their allowance/pocket money. I haven’t done much research yet – the older one is just realizing the concept of money, so this is a ways off (she knows not to buy Paw Patrol episodes on Amazon now, at least!)

UK Junior ISA (Account Options)

This is a really quick one for completeness. A Junior ISA won’t be part of your own retirement/FIRE planning, but maybe something you consider for your kids. They come in both cash and Stocks & Shares (S&S) flavors – the rules are almost the same as adult ISAs. I’ve only called out the handful of differences below, for more details see the cash ISA and S&S ISA pages.

Synopsis

Child versions of cash and S&S ISAs – potentially a good way of saving for your kids’ futures.

Priority

If you’re trying to save for your children, this can make sense, particularly the S&S version, as long as you’re comfortable investing in individual stocks on their behalf. You get partial tax advantages (UK only) and the chance of a higher return than a savings account.

I don’t see much value in the cash version, because of the generous personal and savings allowances. You’re probably better off just opening a savings account, where you’ll get equal or better interest and you can get they money when you need it.

Eligibility

UK residents age 0 to 17. The child is the account holder – once they turn 18, it’s their money and they can do whatever they want with it. You might want them to pay for university housing, but they might want to blow it all clubbing in Ibiza and you can’t stop them.

Note that there is overlap here with the adult cash ISA – kids aged 16 and 17 can have both a junior ISA and an adult cash ISA.

Withdrawal Options

Until the child turns 18, you can’t touch the money. The only exceptions are death or terminal illness of the child, which we’re all certainly hoping won’t happen.

Once the child turns 18, the account turns into an adult ISA and the money can be withdrawn as needed.

Contributions LImit

£9,000 per year, per child – this can be split between cash and S&S or all in one.

Tax & Fees

Basically all the same as an adult cash or S&S ISA.

Further Reading

MoneySavingExpert on Junior ISAs

Alternative Minimum Tax & Americans Overseas

I just finished my 2020 US taxes, and while reviewing them noticed that I had a chunk of Alternative Minimum Tax, over $600! Fortunately, it was offset by my child tax credits (thanks girls!), so I didn’t actually owe any tax, but it got me to thinking. My kids are growing up fast, and there will come a time when I won’t have child tax credits – will I actually wind up paying AMT to the US government, despite my UK foreign tax credits?

This post explores what the AMT is and how it applies to Americans living outside the US – the example uses UK numbers for the amount of foreign tax paid, but the concept applies anywhere that has generally higher tax rates than the US.

Caveat up front: the Alternative Minimum Tax and the Foreign Tax Credit are both very complicated bits of the US tax system – mash them together, and my head starts to hurt quickly. I am not a tax professional, and I’m not going to try to explain AMT or FTC in any detail; this is not a guide on how to file your taxes. What I want to explore is why AMT is showing up on my 1040 and how it might apply to you, at a conceptual level.

Personally, I think FTC + AMT is right about the limit of what a non-specialist person is reasonably capable of doing for their taxes – typical tax software doesn’t help much in guiding you, and if you aren’t eager to read a lot of IRS instructions, it might be time to get help.

As I wrote this post, I realized that I was making a sub-optimal decision around the “simplified limitation election” – this fairly arcane term could end up costing you money if you aren’t careful. I’ve learned my lesson, and it’s not the end of the world to fix (I think), but I wanted to share my missteps with you. This stuff is complicated, and the more we can share our learnings, the better prepared we all are.

Bottom line up front: If you have a moderately high income (about $113k+ for MFJ) and are having to do AMT calculations, you probably do not want to elect to use the “simplified limitation election”, or at the least you want to calculate it out both ways the first time you do. Otherwise, you could wind up actually paying AMT.

I’m going to try to keep this discussion reasonably high level, but a certain amount of discussion of forms and schedules and the like is unavoidable in trying to make sense of this subject – it really is the details that matter. Sorry!

It might help to open the relevant forms and follow along:

Quick Background on the AMT & FTC

The AMT is designed to “catch” US taxpayers who have lots of credits, deductions, exemptions, etc. and make them pay their “fair share.” It was originally designed for very high income people, but has drifted down to more average taxpayers over the years.

If you claim the FTC (like most people should, in countries with generally higher tax rates than the US), the form 1040 instructions require you to fill in Form 6251, “Alternative Minimum Tax – Individuals”. That doesn’t necessarily mean you owe AMT, but you need to calculate it to see.

The AMT form 6251 is basically an abbreviated version of your whole tax return, adding back in a bunch of deductions that are included in your “regular” tax calculations but excluded from AMT calculations. This includes recalculating your foreign tax credits, using the AMT numbers. These calculations result in an “alternative minimum taxable income” (AMTI) which is subject to AMT tax rates. If this AMTI is greater than the AMT exemption (for 2020, $113,400 for married filing jointly, $72,900 for single), then AMT tax gets imposed at a 26% rate (28% for AMTI over $98,950 above the exemption).

Following that? Me neither – let’s work through an example, that helps it make a lot more sense.

Meet Prosperous Polly (again)

You remember Polly from my post on US vs US taxes, right?

  • Polly earns £100,000 from her wages, and contributes 5% to her UK pension which is matched at 5% from her employer
  • She’s married to Pat – we’ll assume that Pat doesn’t have any income for this example (we previously assumed some self-employment, but that just muddies the conceptual waters for AMT & FTC)
  • Polly and Pat don’t have any other income – no interest, dividends, capital gains, etc. I know most people will have some of this, but it doesn’t make a material difference here and simplifies the story, so go with it
  • Polly and Pat are US citizens living in the UK
  • Assume a pound buys $1.40

Let’s walk through calculating Polly & Pat’s taxes – not line by line, but at least in conceptual chunks. I’m using the 2020 versions of all the forms; line numbers might change a bit from year to year.

Form 1040 – Income & “Regular” Tax
  • Line 1 – Wages – $147,000 (£100,000 + £5,000 converted to dollars, and assuming that Polly is not taking the treaty position to exclude her or her employer’s pension contributions)
  • Line 12 – Standard Deduction – $24,800 (Polly & Pat don’t have any deductions worth itemizing, like most of us these days)
  • Line 15 – Taxable Income – $122,200 (just $147,000 wages minus the $24,800 standard deduction)
  • Line 16 – “Regular” Tax – $18,464 (there’s a simple formula to get here, taking account for the progressive tax system – Polly & Pat are in the 22% bracket, so pay 22% on their last dollar)

So far, so simple – a basic, boring 1040 tax return for just wage income. But then we get to line 17: “Amount from Schedule 2, line 3”.

Schedule 2, line 3 is the sum of two other taxes: alternative minimum tax and “excess advance premium tax credit repayment.” Polly & Pat don’t have any of the latter, it’s to do with health insurance purchased on the US insurance marketplace, but they do need to calculate the AMT.

Form 6251 Part 1 – Alternative Minimum Taxable Income
  • Line 1 – Taxable Income – $122,200, just copied from form 1040 line 15
  • Line 2a – Standard Deduction – $24,800
  • Lines 2b through 2t and 3 are all kinds of other deductions and adjustments that get added back in. Polly & Pat don’t have any investment interest expense, mining costs, intangible drilling costs, or any of the other stuff on this list.
  • Line 4 – Alternative minimum taxable income (AMTI) – $147,000 (just Polly’s wages & employer pension match, right back where we started)

AMTI is the income that the AMT will be based on. In Polly’s simple case, it’s just her income, without subtracting off the standard deduction.

Form 6251 Part 2 – Alternative Minimum Tax
  • Line 5 – Exemption – $113,400 (this is the exemption for married filing jointly, unless AMTI is over $1,036,800 – it takes the place of the standard deduction for AMT purposes, only income over this exemption amount is subject to AMT)
  • Line 6 – Alternative minimum taxable income over the exemption – $33,600 (just AMTI minus the exemption)
  • Line 7 – Alternative minimum tax before the AMT FTC – $8,736 (in Polly’s simple case, this is simply 26% of the income over the exemption. With capital gains, dividends, or the Foreign Earned Income Exclusion, this gets more complicated. The rate goes up to 28% above $197,900 of taxable income over the exemption)
  • Line 8 – Alternative minimum foreign tax credit

This is just a single line, but now it pushes us into a whole new form, Form 1116, “Foreign Tax Credit.” We’ll wind up doing this form twice, once for “regular” taxes and again for the AMT; let’s start with the regular version and then we can see how it’s different for AMT, because that’s where the real impact can be for Americans abroad.

Form 1116 Part 1 – Taxable Income from Outside the US

Form 1116 is set up so that you must do one form for each “category” of income, including up to three countries per form. In Polly’s case, she only has one category (General) and one country (the UK).

Many Americans overseas will also have Passive category income (interest, dividends, capital gains, etc.), the others are less typical. For the AMT, you have to do each category twice, so a typical tax return for an American overseas could have four copies of the form 1116.

One twist is the “simplified limitation election” – that allows you to use the Part 1 numbers for your AMT version without calculating them again. If you’re using tax software like me, there wasn’t much background on this – I just kind of figured “simple is good” and went for it. Bad move, it turns out, but we’ll see why in a bit. The fun of this is whether you pick simple or non-simple, you’re stuck with that forever, unless you ask the IRS’s consent to change.

  • Line 1a – Gross income from the UK – $147,000 (Polly’s is simple – all her General category income is from the UK, and she only has General category income)
  • Line 3a – Standard Deduction – $24,800
  • Line 6 – Total deductions & losses $24,800 (there are some calculations to get here, basically apportioning your deductions and losses to the category and to the country. Polly’s case makes this simple – she only has the standard deduction, only has one country, and only has General category income).
  • Line 7 – Taxable income from sources outside the US for this category – $122,200 (just Polly’s gross income minus the standard deduction)
Form 1116 – Part II – Foreign Taxes Paid or Accrued
  • Boxes (j) and (k) – Paid or Accrued? Polly has to option to select that she has either paid or accrued her UK taxes. She’s had UK tax taken out of her paychecks throughout the year, so she’s paid HMRC with every paycheck. She’s kept all her paystubs, so can do some quick math to add it all up. You can’t rely on the UK’s end of year tax documentation, like a P60, because the US and UK use different tax years (the US uses 01 Jan to 31 Dec, the UK uses 06 Apr to 05 Apr).
    • Polly selects “Paid”
    • This is another long-lasting selection – if you pick “Accrued”, you have to stay with it forever. If you pick “Paid”, you can later change to “Accrued”. I won’t go into the pros and cons today – at least for the UK, it typically doesn’t make much difference in the end, and Paid is easier to keep track of.
  • Line 8 – Foreign taxes paid/accrued for this category – $38,360 (Polly’s £27,400 UK taxes converted to dollars)
Form 1116 – Part III – Figuring the “Regular” Credit

Here’s where the Regular and AMT calculations diverge, under the simplified limitation. It’s the same form, but using slightly different numbers. Let’s do the regular FTC first.

  • Line 9 – Foreign taxes paid/accrued for this category – $38,360 (copy from line 8)
  • Line 10 – Carryback or Carryover – $0 (we’ll assume Polly doesn’t have any carryover from previous years – it doesn’t make a difference here anyway, she’ll have more than enough foreign taxes paid that she can’t use them all)
  • Line 14 – Foreign taxes available for credit – $38,360 (total of lines 9, 10, 12, and 13; we skipped lines 12 and 13, they don’t apply to Polly)
  • Line 15 – Taxable income from sources outside the US for this category – $122,200 (copy from line 7 – copy this down to line 17, because line 16 doesn’t apply to Polly)
  • Line 18 – Taxable income – $122,200 (copy from form 1040 line 15, this is just Polly’s income minus the standard deduction)
  • Line 19 – Divide line 17 by line 18 – 1.0000 (this is calculating what percentage of your taxable income came from this foreign category – for Polly, it’s 100%. If you have any income in another category or from the US, this number will be less than 1).
  • Line 20 – Regular Tax – $18,464 (copied from form 1040 line 16, this is Polly’s “normal” tax without considering the AMT).
  • Line 21 – Maximum FTC for this category – $18,464 (line 19 times line 20; conceptually, you can only take a credit up to the percentage of the tax you owe that is coming from this foreign category. For example, if 80% of your income is foreign general category income and 20% is US general category income, you can only take a FTC to offset 80% of your tax, the IRS wants to get paid for the 20% that came from the US. We’ll skip line 22 and also use this for line 23).
  • Line 24 – Foreign tax credit for this category – $18,464 (the smaller of line 23, the maximum FTC for this category, and line 14, the actual foreign taxes paid for this category. You can’t take a credit for more taxes than you paid! In Polly’s case, and for most UK residents, you’ll have paid more tax to HMRC than you’re allowed to claim, because the UK income tax rate is higher than US federal income tax rates).

At the end of all that, what we’ve calculated is that Polly can take a “regular” foreign tax credit for $18,464 – exactly the amount of “regular” tax that she would have owed the IRS without the credit, reducing her tax to zero.

There is a Part IV that totals together different categories of FTC – this won’t make any difference to Polly, since she has only one category of FTC. If you have more than one category, the note here is that you can still only take a credit up to the amount of your “regular” tax – if your general and passive FTCs add up to more than your regular tax, you’re capped at taking the regular tax to zero. The FTC isn’t refundable, the IRS will not pay you back for what you’ve paid to HMRC 😦

Form 1116 – Part III – Figuring the AMT Credit using the Simplified Limitation Election
  • Line 14 – Foreign taxes available for credit – $38,360 (same as the regular FTC)
  • Line 17 – Net foreign source taxable income – $122,200 (for the simplified limitation, you just copy this from line 17 of the regular form 1116)
  • Line 18 – Taxable income – $147,000 (this is the big difference from the regular FTC, where it was $122,200. There’s a “worksheet for line 18” to get to this number, but for Polly’s simple situation without qualified dividends or capital gains, this number is her total income, before taking off the standard deduction. For the regular FTC, it’s after taking off the standard deduction)
  • Line 19 – Divide line 17 by line 18 – 0.8313 (the difference carries on – because line 17 is net foreign source taxable income after taking off the standard deduction, but line 18 is taxable income before taking off the standard deduction, line 17 will always be less than line 18, limiting the credit)
  • Line 20 – Alternative Minimum Tax before the AMT FTC – $8,736 (copy from way back, form 6251 line 7. This is different from the regular FTC, because we’re going to figure out how much of the AMT we can apply the credit against, not how much regular tax we can offset).
  • Line 21 – Maximum AMT FTC for this category – $7,262 (line 19 times line 20. Because line 19 is always less than 1.0, this amount will always be less than the AMT before the FTC – Polly will owe AMT. Copy this down to line 23, because line 22 doesn’t apply to Polly)
  • Line 24 – AMT Foreign tax credit for this category – $7,262 (the lesser of the maximum AMT FTC or the actual foreign taxes paid. For the UK, this will almost always be the maximum AMT FTC).

Now we finally have our AMT FTC, we can go back to the AMT calculations and apply it. If Polly had more than one category of FTC to calculate, we’d do that in Part IV, but since she only has general category foreign taxes, it’s the same value as line 24.

Form 6251 – Part II – Alternative Minimum Tax (continued)
  • Line 8 – Alternative minimum tax foreign tax credit – $7,262 (from line 24 on form 1116)
  • Line 9 – Tentative minimum tax – $1,474 (line 7, the AMT before the FTC, minus line 8)
  • Line 10 – Regular Tax minus regular foreign tax credit – $0 – (this makes sense – under the regular tax system, Polly’s foreign tax credit completely offsets her regular taxes)
  • Line 11 – Alternative minimum tax – $1,474 (line 9 minus line 10)

This $1,474 is what Polly & Pat will actually owe in Alternative Minimum Tax. This shows up back on form 1040 on line 17 as an additional amount of tax, above their “normal” tax. There’s only a handful of lines after this before you get to what you actually owe: child tax credit is probably the most common. If Polly & Pat have kids, they can wipe out the AMT amount and they wind up owing nothing (or even get paid by the IRS). But without kids or a few other credits, Polly & Pat could actually pay the IRS, despite all their foreign tax credits!

Obviously, Polly & Pat don’t want to do this, and neither do I. So, let’s go back a bit and revisit that “simplified limitation election” – we’ll recalculate Polly & Pat’s AMT FTC using the non-simplified method.

Form 1116 – Part I & II – Taxable Income from Outside the US & Foreign Taxes (AMT non-simplified limitation)

Basically, the non-simplified method requires you to redo the whole foreign tax credit form 1116, but only using income and deductions that are both allowed for the AMT and attributable to sources outside the US. This can get complicated, but it’s not too bad for Polly & Pat:

  • Line 1a – Gross Income from the UK – $147,000 (still the same, this hasn’t changed)
  • Line 3a – Standard Deduction – $0 (this is the key change! instead of reducing Pat’s foreign taxable income by the standard deduction, it stays the same, because the standard deduction isn’t allowed by the AMT)
  • Line 7 – Taxable income from sources outside the US for this category – $147,000 (just Pat’s taxable income, no deductions)
  • Line 8 – Total foreign taxes paid/accrued for this category – $38,360 (no change from the regular calculation
Form 1116 – Part III – Figuring the AMT FTC (non-simplified limitation)

Let’s do this calculation for the third time – now we’re using the data from the AMT Part I & II, following the instructions for form 6251 that tell us how to do the calculations for AMT.

  • Line 9 -Total foreign taxes paid/accrued for this category – $38,360 (copy from line 8)
  • Line 10 – Carryback or Carryover – $0 (still assuming zero, still doesn’t make a difference)
  • Line 14 – Foreign taxes available for credit – $38,360 (total of lines 9, 10, 12, and 13; we skipped lines 12 and 13 again)
  • Line 15 – Taxable income from sources outside the US for this category – $147,000 (here’s where the non-simplified method makes a difference – this value was $122,200 for the simplified method. Just copy from line 7, then we copy this down to line 17, because line 16 doesn’t apply to Polly)
  • Line 18 – Taxable income – $147,000 (this is the same number as using the simplified method, but now lines 17 and 18 are the same number)
  • Line 19 – Divide line 17 by line 18 – 1.000 (because of the non-simplified method, we’re now able to take a credit against 100% of the AMT, not just the 83% we could with the simplified method)
  • Line 20 – Alternative Minimum Tax before the AMT FTC – $8,736 (copy from form 6251 line 7, same as the simplified method. ).
  • Line 21 – Maximum AMT FTC for this category – $8,736 (line 19 times line 20 – copy this down to line 23, because line 22 doesn’t apply to Polly)
  • Line 24 – AMT Foreign tax credit for this category – $8,736 (the lesser of the maximum AMT FTC or the actual foreign taxes paid. For the UK, this will almost always be the maximum AMT FTC).

Now we’ve got an AMT FTC that is equal to the preliminary AMT amount – you can see where this is going now.

Form 6251 – Part II – Alternative Minimum Tax (non-simplified AMT FTC)
  • Line 8 – Alternative minimum tax foreign tax credit – $8,736 (from line 24 on form 1116)
  • Line 9 – Tentative minimum tax – $0 (line 7, the AMT before the FTC, minus line 8)
  • Line 10 – Regular Tax minus regular foreign tax credit – $0 – (this makes sense – under the regular tax system, Polly’s foreign tax credit completely offsets her regular taxes)
  • Line 11 – Alternative minimum tax – $0 (line 9 minus line 10)

Now we carry this back to form 1040 line 17, via schedule 2 lines 1 and 3. But since the value is zero, it’s easy to see that there’s no AMT payable. And since the “regular” FTC is equal to the “regular” tax, the tax owed is reduced to zero. If there are any refundable tax credits, like part of the child tax credit, Polly & Pat get paid to file their taxes. Even without the refundable part, they owe nothing! Much better result than the simplified limitation.

So What?

That was a really, really long winded way of saying that you should definitely do some calculations before you decide whether or not to use the “simplified limitation election” – if your situation is similar to Polly & Pat, it could cost you!

For me, understanding this much better now, I need to switch to the non-simplified method moving forward. I’m lucky to have only filed two years with the simplified method, and in both of those I had enough child tax credit that the AMT didn’t make any difference at all (the non-refundable part of the child tax credit was more than my AMT, so I still got the full amount of the refundable portion).

So I’ll write the IRS a letter, requesting consent to switch to the non-simplified method for 2021 onwards and explaining the situation (in a LOT less detail). Given how backed up they are these days, I may not even hear back before I file my 2021 taxes, but I’ll plan on using the non-simplified method – even if it takes them a year+ to respond, it won’t change the bottom line on my taxes until the kids grow out of the child tax credit.

If I hear back anything other than “that’s fine, go ahead”, I’ll provide an update so we can all learn together.

Further Reading:

IRS Training on calculating AMT FTC – this was helpful in understanding the calculations more conceptually than just using the form instructions

US and UK Taxes – Which are higher?

The UK, right? Lots of people make the assumption that the UK is a high tax country, with a generous social safety net funded from those high taxes (some people I know would disagree with how generous – more than the US in a lot of cases, at least, but no Norway!).

I wanted to see if that’s actually a good assumption, because I’ve looked at my own situation and while my UK taxes are a bit higher than my US federal taxes, when you look at other taxes plus health care, it seemed pretty close.

Spoiler: US federal taxes are lower than UK income taxes, but when you put in typical state taxes and health insurance, it gets pretty close. Read on for more!

Background – Tax Brackets

The US and the UK both work on a marginal and progressive tax system: the percentage tax you pay on your highest dollar/pound of income is not the same as on your lowest, and the rate is higher on higher incomes. I know that’s income tax 101, but it’s really important – the first pound that you make over the 40% threshold gets taxed at 40%, but all the others are at 0% or 20%.

I started to type out the US and UK tax brackets here, and then I remembered you guys can read:

  • UK Tax Brackets (there’s a hidden bracket between £100,000 and £125,000 where the personal allowance is reduced by £1 for every £2 extra earned – this results in a small but painful 60% tax bracket).
  • US Federal Tax Brackets

Both countries also have some other taxes that get added on to the income taxes – National Insurance in the UK and FICA (Social Security & Medicare) in the US.

Both systems offer a variety of ways of reducing your taxable income – deductions, credits, pension contributions, etc. For most of us planning for retirement, the biggest one will be those pension contributions, although others can be significant in your particular situation (child tax credit is a big one in the US, and part of it is refundable – can be free money for Americans in the UK!).

Instead of going through a bunch of theoretical math, I thought it might be easier to illustrate in two examples. I picked two examples that aren’t in the extremes of high or low income: Average Andy, who is pretty average, and Prosperous Polly & Pat, who are at the high end of the income scale but before you start getting to really crazy money – probably roughly typical of somebody planning for FIRE. These are just illustrative, and they avoid the complications that creep in at very high and very low levels of income.

Example 1 – Average Andy

Meet Andy – he’s pretty average. He’s 30 years old and makes £40,000 or $56,000 a year, pretty close to the median salary for a full-time employee in the US or UK. He’s single, doesn’t have any income outside his job, and contributes 5% to an employer pension (without salary sacrifice) or 401(k), reducing his taxable income to £38,000 or $53,200. We’ll ignore any employer matches, since those vary tremendously by job in both countries and don’t really impact the tax calculations.

Andy’s UK Taxes

Andy’s £40,000 breaks down like this:

  • Income Tax: £5,098
  • National Insurance: £3,660
  • Pension: £2,000 from Andy, £500 from HMRC as a tax benefit
  • Take Home Pay: £29,242

In total, Andy pays the government £8,758 and gets to keep £31,742 of his total £40,500 effective pay (since HMRC tops up his pension with £500). That’s a 21.6% overall tax rate. That’s also pretty much the end of the story – there’s no state tax and he gets the NHS thrown in for “free”. There are VAT and council tax, but those are based on consumption more than income, so we’ll ignore them.

Andy’s US Taxes

Andy’s $56,000 breaks down like this:

  • Federal Income Tax: $4,766
  • FICA (Medicare & Social Security): $4,284
  • 401(k): $2,800 from Andy – nothing directly from the IRS, but this income is deducted from his taxable income
  • Preliminary Take Home Pay: $46,950

Right now, we’re at Andy having an overall 16% tax rate. But wait! Andy might still need to pay state tax. This varies all over the place, from 0% to over 10%. Let’s split the difference and call it 5% – that just happens to be the actual income tax rate in Massachusetts, after the standard deduction (actually on the lower end if you rank them all out – not so bad for Taxachusetts!)

  • State Income Tax: $2,440

Now we’re at $44,510 (£31,792) – still doing better than UK Andy. But US Andy needs to pay for health insurance! This could be all over the place, depending on what (if anything) his employer offers. I found all kinds of numbers researching this post, but went with the Kaiser Family Foundation’s average employee contribution of $1,489 in 2019 for the employee part of individual health insurance.

  • Health Insurance: $1,489

That doesn’t account for any deductibles or other health spending not covered by his insurance – let’s assume Andy is perfectly healthy and fortunately doesn’t have to use it. That’s good, because average annual deductibles are typically in the thousands!

That leaves US Andy a $43,021 ($30,729) take home, and overall he gets to keep $45,821 (£32,729) of his $56,000 salary, for an overall 18.2% tax + health insurance rate.

Who wins, US or UK Andy?

To me, this is a tossup. US Andy gets to keep an extra £1,063 of his hard earned cash, but if he has any health issues, that’s coming right out of his pocket, at least until he hits his deductible.

However, he’s also contributing to the rather more generous US Social Security scheme, compared to the UK State Pension (I’ll do a post on this in the future, but simple version is that the max Social Security benefit at age 66 is about $3,148 a month, State Pension at age 68 is about £759.20 a month – both of those can increase by delaying, but State Pension isn’t going to catch up).

Either way, this isn’t a clear case of “UK taxes are way higher than the US” – they’re pretty close, especially once you put state taxes and health insurance into the equation.

Example 2 – Prosperous Polly & Pat

Polly is doing well – in the top few percent of the US or UK, earning £100,000 a year ($140,000), all from her job. Her spouse, Pat, mostly stays at home with their two kids, but has a small self-employed business earning £5,000 ($7,000). Polly contributes 5% a year to her pension/401(k).

Polly & Pat’s UK Taxes

Polly & Pat file their UK taxes separately, since there’s no such thing as a joint return:

CategoryPollyPatTotal
Income Tax£25,496£0£25,496
National Insurance£5,860£0£5,860
Pension£5,000 from Polly,
£3,333 from HMRC
£0£8,333
Take Home Pay£63,644£5,000£68,644

Pat & Polly pay the government £31,356 and gets to keep £76,977 of their total £108,333 effective pay (since HMRC tops up Polly’s pension with £3,333). That’s a 28.9% overall tax rate – a chunk more than Andy’s 21.6%. As with Andy, that’s about it – no state taxes, NHS included.

Polly & Pat’s US Taxes

Polly & Pat’s US taxes get lumped together, since they’re filing jointly:

  • Federal Income Tax: $12,053 (including 2 child tax credits at $2,000 each – this would change for 2021 with the recent increases to the child tax credit to $3,000 or $3,600 each, but for now it looks like that’s a COVID one-off for 2021)
  • Polly’s FICA: $10,596
  • Pat’s Self Employment Tax: $706 (half of this is deductible from the federal income tax, already included in the number above)
  • 401(k): $7,000 from Polly
  • Preliminary Take Home Pay: $116,645

So far, US Polly & Pat get to keep $123,645 of their $147,000 income, only a 15.9% tax rate compared to UK Polly & Pat at 28.9% – a big difference! But, let’s add in state tax – again assuming 5% Massachusetts flat tax:

  • State Income Tax: $6,460

And, let’s not forget health insurance – because it’s for a family, the rates go up:

  • Health Insurance: $5,726

And again, we’re assuming no deductibles actually get used – no emergency room visits from accidents with the kids, no health scares, etc.

Take off the state income tax and health insurance, and now we’ve got a take home of $104,459 – with the 401(k), US Polly and Pat get to keep $111,459, for an overall tax + health insurance rate of 24.2%.

Who wins, US or UK Polly & Pat?

This one is a bit further apart – in the UK, Polly & Pat are paying an effective tax rate of 28.9%, while in the US it’s only 24.2% – in the US, they get to keep more than £2,600 ($3,640) more of their hard earned money, about an extra £220 in their pocket every month.

Throw in a few medical expenses and you get pretty close, though – while the US probably comes out slightly cheaper here, I’d say that again it’s not a runaway winner.

Also, Polly’s pension/401(k) contributions are pretty low – she might be able to afford more. She probably won’t get out of the 40% band in the UK or the 22% bracket in the US, but every extra contribution makes a solid difference at those rates.

Implications for Americans in the UK

One thing these examples do reinforce is the common assumption that UK income taxes on any given bit of income are higher than US. That’s a useful simplifying assumption when thinking about your taxes, because it means, for most kinds of income, you’ll get a Foreign Tax Credit that is larger than what you owe the US, so you don’t actually owe anything.

That gets a little dicer for capital gains, dividends, and interest, since the UK has somewhat generous exemptions for these (up to £12,300, £2,000, and £1,000, respectively), where you won’t get FTCs for income that the US taxes.

On the whole, though, if you’re paying attention to how you earn and invest and making sure it’s friendly to both systems, you aren’t likely to owe Uncle Sam much, if anything. Various exceptions apply for specific situations, but it’s typically not far off!

Sources:

US Tax Calculator

UK Tax Calculator

UK & US Savings Accounts (Account Options)

I’m lumping these together because there’s no practical difference, aside from the currency. These aren’t really investment accounts, but just to cover the rest of the universe of accounts that Americans in the UK might have.

Synopsis

Short term savings or emergency fund only – low interest rates, often below inflation. There might be some deals that beat inflation, although they’re often only for smaller amounts.

Priority

Once you’ve built an emergency fund and put it somewhere safe, there’s no reason to keep building up value in a savings account. The exception would be short term goals – a house purchase or renovations, new car, special vacation, etc.

Eligibility

Pretty much everybody – special kids savings accounts for people under 16 or 18.

Risk & Return

Very safe, but with typically low interest rates.

UK accounts are insured by FSCS up to £85,000 per financial institution (with a caveat that several different “brands” of banks may be the same actual financial institution. For example, Halifax and RBS are part of the same financial institution, so two accounts, one with each, would only be covered to a total of £85k). There are also provisions for temporarily higher balances, like when you’re moving money around between a house sale and another purchase. More details on MoneySavingExpert

US accounts are insured by FDIC up to $250,000 per depositor per bank.

Withdrawal Options

Withdraw any time with no penalties, unless it’s a “fix” or “limited access” account in the UK, or the similar “Certificate of Deposit” in the US.

Contribution Limit

Typically none, although some accounts may have specific limits – “regular savers” are popular in the UK, where you can only put in a maximum amount per month, but they typically pay higher interest.

Fees

Typically none, unless you need to access a limited account early.

Tax Treatment – Contributions

Post-tax money for both the US and UK, no benefits.

Tax Treatment – Withdrawals

Interest is taxable as income in both the US and UK. The UK has a Personal Savings Allowance that means that most UK taxpayers don’t pay tax on interest. Only interest above the following amounts is taxable:

  • 20% tax bracket: above £1,000
  • 40% tax bracket: above £500
  • 45% tax bracket: all interest is taxable

The US doesn’t have a similar system, so if you make £100 interest in a UK bank account, you could pay US tax on it (depending on what the rest of your return looks like with deductions, foreign tax credits, etc.).

Further Reading

MoneySavingExpert on UK savings accounts

I haven’t found a similar site for US accounts (lots of kind of scammy sites out there, or ones looking just to drive affiliate revenue), but if you know of one I’ll happily add it.

US 529 College Savings Account (Bad Account Options)

Bad might sound dramatic, but this one is a bit of a conundrum – I really don’t see any positives, but plenty of headaches. Short answer – if you’re in the UK or thinking of moving sometime and you don’t already have a 529 for your kids, don’t open one. If you’ve already got one, read on.

What are the problems with a 529?

  1. There are no UK tax advantages – it’s a taxable brokerage account. This alone isn’t a massive problem – it’s the same way with an HSA, or with the US non-recognition of an ISA. It’s annoying and requires some planning, but manageable.
  2. It might be a trust – there are a number of articles out there describing various scenarios. Some of them are potentially even advantageous, if you a) trust them and b) know how to use them. But the simple version is trusts are complicated. If you want to keep a 529 and especially if you want to use the fact that it might be a trust to your advantage, you should probably talk to a professional.
  3. Whether or not it’s a trust, you probably can’t invest in HMRC reporting funds (and it’s certainly not a “pension scheme”). I have yet to find a 529 that offers HMRC reporting funds as an option – they seem to be mostly proprietary mutual funds. That means that not only are your gains in the 529 taxable in the UK, they’re taxable as income, not capital gains. What’s the difference? A 45% max tax rate instead of 20%.
  4. Lastly, if your child is staying in the UK, UK college expenses may not be that expensive anyway, and they may be eligible for very advantageous student loans (very rough version: a 9% tax on higher income earners that gets forgiven at age 50 if they aren’t repaid by then). This gets complicated, depends on the nationality and residence of the children and parents, etc. – certainly encourage you to do some research here and understand how much you might need to save. A couple good places to start are gov.uk on student finance and UCAS on tuition fees and student loans.

Add all that together, and you’ve got a tax-disadvantaged account that’s potentially complex and trying to solve a problem that may not be that bad in the first place.

What to do about an existing 529?

I was in this situation myself, and can only speak to the options that I uncovered as I tried to figure it out. I imagine there are some other options out there, and I welcome any suggestions!

In rough order of least to most pain:

  1. Close the 529 before leaving the US. You pay capital gain tax on any gains plus a 10% penalty – that hurts, but then it’s done and you never have to think about it again.
  2. If you’re already in the UK, but are planning to go back to the US, it might be ok to just leave it open and don’t touch it. More research needed on how UK tax works here, and likely you’ll want some professional advice!
  3. If you’re already in the UK and not planning on going back to the US, you can close it and pay the piper. That’s UK tax on any gains since moving to the UK (at income tax rates and without benefit of the Capital Gains Allowance, assuming the funds aren’t HMRC reporting), US capital gains tax on any overall gains (possibly offset by Foreign Tax Credits), and the 10% US penalty. This really hurts, but then it’s done – this is what I’m in the process of doing now.
  4. Keep it and figure out the complexities of being able to actually use it when your kids go to college. I’d be interested in any stories on how this works out in practice!

Where should I save for college?

If you need to save for college at all, given the UK’s often lower fees and friendlier student loans, you’ve got a few options:

  • ISA: Either a Junior ISA, or your own ISA. Remember, there’s no penalty on withdrawals, although you will pay US tax. Junior ISA gets you an extra £9,000 annual allowance if you’re already using your £20,000 allowance, but the account becomes fully your kid’s at 18, to do with as they wish.
  • Taxable account: any kind, whether it’s a brokerage account, savings account, etc. Obviously it’s fully taxable, and what you should invest in will depend on the details, but there’s no penalty for withdrawing whenever you like (just have to pay any taxes due on gains), and you can easily change your mind and use it for something else of your choice.
  • Junior SIPP: Not for college, since you can’t access it until age 57, but if you’re trying to set your child up for the long-term future, this is an option worth exploring further.

US Employer Pensions (401(k), etc.) (Account Options)

This is a big one – it might be limited in your ability to contribute moving forward, but for many Americans who move to the UK after starting their career in the US, you’ve got one or more employer pension accounts, possibly with substantial balances.

For our purposes, the rules are pretty much the same all of this diverse family of accounts: 401(k), Solo 401(k), 403(b), Thrift Savings Plan, 401(a), SEP IRA, and SIMPLE IRA. These all have significant differences from a US resident perspective, in terms of how much you and an employer can contribute, etc., but they’re all “pension schemes” for the purposes of the US/UK tax treaty.

I’m also assuming that you aren’t in a position to contribute further. That’s not necessarily true if you’re self-employed or working in the UK for a US employer – I’ll ignore those cases for the purposes of this post, though. Same with the possibility of opening one of these accounts while in the UK – that could get pretty complicated.

These accounts can also be rolled into an IRA – I won’t explore that option today, but it’s something I want to look into in an upcoming post, especially since it opens the door to a Roth conversion.

Synopsis

You can keep all these plans once you move to the UK, and enjoy the tax advantages in both countries. For some people, rolling them into an IRA may be an even better option – that decision will depend on your specific circumstances.

Priority

N/A, you typically can’t contribute while in the UK – if you’re in a less typical situation and are able to contribute, these plans are likely one of your first options, being roughly equivalent to a UK employer pension.

Investment Options

This will depend a lot of the exact plan, but you’re usually looking at a variety of mutual funds – stock, bonds, US, world, etc. Hopefully you’ve got some options for low-cost index funds, but not always.

PFIC and HMRC reporting funds rules don’t apply, since this is a pension and thus covered under the tax treaty (you probably won’t have a PFIC as an option, anyway).

Risk & Return

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

Withdrawal Options

Typically, you can withdraw from age 59 1/2 without penalties, while earlier withdrawals attract a penalty (with some exceptions). You must usually start taking Required Minimimum Distributions from age 72.

If you’re still working for a US company, there’s an option to retire from that company at 55 and start withdrawals then, although that’s pretty rare for Americans in the UK and has some specific rules.

If it’s a Roth account, you can withdraw the contributions early without paying a penalty, but not any gains.

Fees

All over the place, depending on the plan. You might have a great plan with rock-bottom fees, or one with terrible fees. If you’re paying much more than 0.1% or so annually, it may be good to look at an IRA rollover to somewhere with better options.

Tax Treatment – Withdrawals

Simple version, for Traditional accounts.

  • If it’s a lump sum payment, the US will tax it but not the UK
  • If it’s recurring payments, the UK will tax them. If there’s any US tax withheld, you can claim it as a UK foreign tax credit.

There’s an implied question here – what is a “lump sum”? The treaty uses the term “lump-sum payment” but doesn’t define it, neither does the US Technical Explanation or the UK Double Taxation manual. There are some strongly worded articles out there about US tax on a UK pension lump sum – that’s particularly interesting because of the 25% tax-free lump sum on a UK pension.

There’s no similar tax advantage to taking a lump sum from a US employer pension scheme – it’s all taxable income and now we’re just debating about who you’ll pay the tax to (and how much).

My unprofessional opinion:

  • Most people want to do recurring payments anyway, which will help keep you in a lower tax bracket. Taking too much at once, like a lump sum, could fairly easily push you into the UK 40% bracket. Recurring payments are pretty straightforward – you pay UK income tax, and claim back any US income tax.
  • If you’re envisaging some way in which a lump sum saves you taxes, talk to a professional – it just gets messy.

For Roth accounts, you’ve already paid tax on the income that you used to contribute to the account, so there’s no tax due on withdrawal. The tax treaty is not 100% clear on this (it doesn’t discuss Roth except for IRAs), but this is the common sense understanding and I haven’t found anybody that disagrees – some cautions about needing to make a treaty-based position on your Self Assessment, so if you have significant Roth balances, it may be worth seeking professional advice to make sure you get it right.

My Asset Allocation (Part 2)

14Apr21: I edited my approach to where to put bonds, based on my post on Required Minimum Distributions.

In Part 1, we discussed the first three of my six steps for asset allocation:

  1. Why are you investing? What are the goals?
  2. What broad asset categories do you want to invest in? Stocks vs bonds, US, UK, International, etc.
  3. What are your percentage targets for each of those asset categories?
  4. Which account types will you use for each asset categories, considering tax treatments?
  5. Which funds will you use in those accounts to achieve the overall asset allocation?
  6. How and when will you rebalance to maintain your target asset allocation?

This post will wrap up with the second half of the list.

Asset Categories & Account Types

Bogleheads has a good primer on tax-efficient fund placement – it’s specific to US investors, but the general concepts apply for Americans investing in both the US and UK, even if some of the numbers will vary (the US and UK systems for taxing capital gains and dividends are very roughly similar).

For more details on any of the account types mentioned below, I’ve put together summaries linked here.

By the nature of the investments I choose, I avoid really tax inefficient options – REITs, high-turnover active funds, and high-yield corporate bonds. The fact that these are tax inefficient just adds to my reasons for not investing in these.

That means the most tax inefficient investments I have are bonds. I keep all my bond funds in a tax-advantaged account that are recognized in both the US and UK: my TSP (similar to a 401(k)). It would also be fine to have a bond fund in a UK pension (including SIPP, as long as you agree it’s a pension) or in a Roth IRA, but there are other advantages to putting bonds in a Traditional IRA or 401(k) account (see my post on Required Minimum Distributions). I also have a number of individual US savings bonds – there’s no choice to hold these anywhere except a taxable account, so there they are.

Individual stocks only live in my S&S ISA (because I don’t want PFICs there), and some RSUs from an old employer that stay where they are because they’re already there. That company won’t be paying dividends anytime soon, so unless I sell, there’s no taxable events there. An IRA is also a perfectly good place for individual stocks, if you particularly want to invest in them.

That just leaves stock index funds. It probably doesn’t really matter where you put these – there are some arguments for where to put US vs non-US and so on, but these are tweaking around the edges. My approach is a combination of simplicity plus taking advantage of accounts where I can get particularly low-cost funds.

  • I keep my taxable account simple, to try to keep my taxes simple: this is all US total stock, in a single index ETF which is HMRC reporting
  • I take advantage of low fees where they’re only available in specific places.
  • After that, it’s just splitting across the account types (TSP, Roth IRA, and UK pension) to achieve the target asset allocation

Fund Selection for Asset Allocation

I’ll quickly run through the funds I use in each of my account types. These are not specific recommendations for these funds – I’m not trying to sell you anything! Just what works for me, do your own research 🙂 There’s nothing extra special about any of these funds, they’re mostly pretty typical index funds.

My key rules, in rough priority order:

  • No PFICs outside pensions
  • No funds that aren’t HMRC reporting outside pensions
  • Minimize costs
  • Follow tax-efficient asset allocation, as described above
  • Keep it as simple as possible
  • US Taxable Brokerage Account
    • 100% Vanguard Total Stock Market Index Fund ETF (VTI) – very low expense, covers the whole US market
  • US Treasury Bonds
    • A chunk of Series EE bonds – my parents bought these for me when I was much younger; they’re now at very competitive interest rates, so I hold on to them to maturity. If you have a 20 year time horizon, these are still an attractive investment for new money, since they’re guaranteed to double in value in 20 years, about a 3.5% interest rate. But if you sell at 19 years and 11 months, you get the pitiful rates of today (0.1% as I write this).
  • US Roth IRAs
    • Vanguard Extended Market Index Fund ETF (VXF) – low expenses, need a bit more small/mid cap to get to my target allocation
    • Vanguard Emerging Markets Index Fund ETF (VWO) – low expenses for the category, this is essentially all of my emerging markets allocation
    • Some more VTI, to get to the target asset allocation.
    • Vanguard Total International Index Fund (VEU) – I don’t have any here at the moment, but its on my list if I ever need it to get to my target international allocation.
  • Thrift Savings Plan
    • I know most of you won’t have access to the TSP, unless you’re a current or former US government employee. It works very much like a 401(k), but has a very short but good list of investment options (all low-cost index funds). If you don’t have a TSP account, you could do something very similar in a good 401(k), or in an IRA you’ve rolled your 401(k) into.
    • International (I Fund): The lowest expense international fund I can find, it’s the core of my international holdings.
    • Large Cap (C Fund): Basic S&P 500 tracker. Combined with VTI, it makes up my US large cap exposure.
    • Small Cap (S Fund): Slightly misnamed, this is really mid and small cap – very similar to VXF. A chunk of my US mid/small cap allocation
    • Fixed Income (F Fund): Mix of about 70% US government bonds, 30% US corporate bonds. The remainder of my bond allocation, after the savings bonds.
    • Government Bond Fund (G Fund): this is a TSP-unique offering, US government bonds issued just to this fund and not traded on the open market. I’m not currently using it, but when I increase my bond allocation in retirement, I likely will.
    • Fixed Income Fund (F Fund): a basic, broadly diversified US bond index fund. I don’t currently use it (BND in my IRA plus savings bonds are enough for my US bond allocation), but certainly would if I needed to.
  • UK Pension
    • Your options will vary tremendously based on the exact plan your employer has selected and who is administering it, so I won’t give specifics on the funds I use. Depending how good or bad your options are, you may even need to readjust the rest of your allocations – I remember having a 401(k) in a previous employer that was so bad I just had to pick the worst of a lot of bad options, and make up for it elsewhere. Even if you only have bad options, it’s worth at least getting the employer match – that’s free money and an instant return!
    • UK Equity Index: you’ll find it challenging to buy a UK index fund outside of a UK pension/SIPP. It’s a PFIC in a S&S ISA, and I haven’t found a UK-only index fund that I’d want to own in a US account. So if you want UK-specific exposure beyond what is already in an a total international fund, this is a good place for it.
    • Ex-UK Equity Index: This goes into a bit of a mix of different asset categories, but works fine to accept my pension contributions. I can tweak other investments to maintain the overall allocation. In my pension, this is a very low cost option, too.
  • UK Stocks & Shares ISA

Rebalancing for Asset Allocation

Rebalancing is simply tweaking the proportion of investments in individual funds in order to maintain the overall target asset allocation. It’s a necessary process – otherwise your allocation will drift as some categories perform better than others, and you wind up over-concentrated in recent winners (which might be primed to underperform), and under-concentrated in recent losers (which might have more room to grow next).

I use two ways of rebalancing:

  • Preferred: adjust where new money goes.
    • I put my annual Roth IRA contributions in the right place to bring up any categories that are low, and occasionally tweak my monthly UK pension contributions to adjust the mix.
    • This has the advantage of not triggering any capital gains, no hassle with selling and buying – it’s easy and free.
    • I am missing out on the possibility of tax loss harvesting in my taxable account, but the simplicity is worth it to me. Plus, my taxable account is a pretty small amount of my overall investment – if it was bigger, this calculus might change.
  • As necessary: sell overweight categories and buy underweight ones.
    • I don’t do this in my taxable account – that’s why it’s all in one investment, it can just stay there and do it’s thing, and I avoid taxable capital gains.
    • Occasionally I need to do this in my TSP or Roth IRAs. TSP is easy (I just type in the new percentages I want and they adjust it overnight), but in an IRA you need to sell one ETF and then use the cash to buy another.
    • This isn’t taxable within the IRA wrapper, but it’s a bit of a hassle, and there’s a risk of the market moving while you’re in cash, missing out on gains (or losses!). So I limit this to roughly annually, usually about the same time I do my Roth IRA contributions.

Conclusions

That’s really all there is to asset allocation! There are a few tweaks to account for US/UK taxes and available accounts, but the overall concept is the same for any investor. I hope this was a useful description, and appreciate any comments or questions (or telling me I’m doing something stupid!).