ISAs and UK Investments Under U.S. Tax: What Stops Being Tax-Free

ISAs and UK Investments Under U.S. Tax: What Stops Being Tax-Free

When you move from the UK to the United States, you bring more than just your suitcase; you bring a lifetime of financial habits and tax-efficient structures. In the UK, the Individual Savings Account (ISA) is the gold standard for personal saving. It is simple and, most importantly, tax-free.

However, once you satisfy the Substantial Presence Test, you become a U.S. tax resident. At that moment, the "tax-free" shield of your ISA effectively dissolves. To the Internal Revenue Service (IRS), an ISA is not a privileged tax wrapper; it is simply a foreign brokerage account subject to some of the most complex and punitive rules in the U.S. tax code.

This guide explores the specific ways your UK investments lose their tax-free status and why "doing nothing" is often the most expensive choice you can make.

1. The IRS "Look-Through" approach

The fundamental issue is that the U.S. does not recognize the UK/U.S. Tax Treaty as applying to ISAs in the same way it applies to pensions. While the treaty protects the tax-deferred status of a SIPP or a workplace pension, it is silent on ISAs.

Because there is no specific treaty provision or U.S. law that grants ISAs tax-exempt status, the IRS "looks through" the ISA wrapper. They treat the account as if it doesn't exist, focusing instead on the assets held within it. So the UK View: You see a single, tax-free pot of money, but the U.S. View: The IRS sees a collection of taxable interest, taxable dividends, and taxable capital gains.

2. Cash ISAs: The interest trap

If you hold a Cash ISA, the tax treatment is relatively straightforward but still a departure from what you are used to.

In the UK, the interest you earn is yours to keep, 100%. In the U.S., that interest must be reported on Schedule B of your Form 1040. It is taxed as "Ordinary Income" at your highest marginal tax rate. If you are a high earner in a state like California or New York, you could see up to 40-50% of your "tax-free" UK interest disappear into federal and state coffers.

The phantom gain on currency

There is an additional layer of complexity: Currency Exchange. The IRS requires all reporting to be in U.S. Dollars. If you hold £50,000 in a Cash ISA and the Pound strengthens against the Dollar over the year, you may find yourself paying tax on a "gain" that only exists because of the exchange rate, even if the balance in Pounds remained the same.

3. Stocks and Shares ISAs

The real danger for UK citizens lies in the Stocks and Shares ISA. Most of these accounts are invested in UK-domiciled mutual funds, OEICs (Open-Ended Investment Companies), or ETFs.

Under U.S. tax law, these are classified as Passive Foreign Investment Companies (PFICs). The PFIC regime was designed to discourage Americans from stashing money in offshore tax havens, but it inadvertently catches almost every standard UK retail investment fund.

Why PFICs are punitive:

• Tax Rates: Gains on the sale of a PFIC are not taxed at the favorable long-term capital gains rate (usually 15% or 20%). Instead, they are taxed at the highest marginal income tax rate possible for the years you held the asset.

• Interest Charges: The IRS assumes you have been "deferring" tax the whole time you held the fund. They apply a compounding interest charge to your tax bill, dating back to the day you bought the fund or moved to the U.S.

• Reporting Costs: Every single PFIC you own requires Form 8621. This form is so complex that the IRS estimates it takes over 20 hours of record-keeping and preparation per year per fund. Most specialist accountants charge several hundred dollars per form, often making the compliance cost higher than the value of the investment itself.

4. Premium Bonds: The "Gambling" problem

National Savings & Investments (NS&I) Premium Bonds are a British institution. Millions of people hold them because the "winnings" are tax-free.

The IRS, however, does not view these as a government-backed savings vehicle. They view the winnings as lottery or gambling income.

1. Taxability: Any prize you win is fully taxable as ordinary income in the U.S.

2. Reporting: Because Premium Bonds are held in a foreign financial account (NS&I), the total value must be included in your FBAR and FATCA disclosures.

5. Dividends and the "Qualified" question

In a standard UK brokerage account (outside an ISA), you might benefit from the 15% treaty rate on dividends. However, inside an ISA, the categorization of dividends becomes messy.

If the underlying assets in your ISA are UK companies, you might qualify for "Qualified Dividend" rates in the U.S. But if they are held through a UK mutual fund (a PFIC), those dividends are often taxed at the much higher ordinary rates. You lose the benefit of the UK's dividend allowance and the U.S.'s lower investment rates simultaneously.

6. Reporting obligations: FBAR and Form 8938

Even if your ISA is "dormant" and you aren't actively trading, the mere existence of the account triggers significant reporting requirements.

FBAR (FinCEN Form 114)

If the combined value of your UK bank accounts, ISAs, and pensions exceeds $10,000 at any point during the year, you must file an FBAR. An ISA is considered a "financial account" for this purpose. Failure to file can lead to penalties starting at $10,000 per violation, even if no tax was actually owed.

FATCA (Form 8938)

If you have higher levels of assets (e.g., $50,000+ for single filers living in the U.S.), you must also file Form 8938 with your tax return. This form requires you to list the maximum value of the ISA, the account number, and the institution's address. Thanks to the Common Reporting Standard, your UK bank is likely already sharing this information with the IRS.

7. The strategy: What to do before you move

At Antravia Advisory, we recommend a "Clean Break" strategy for UK investments before you establish U.S. residency. Because the U.S. tax system is so aggressive toward foreign "wrappers," the most efficient path is often the simplest one.

Liquidate and Re-invest

Consider liquidating your ISA and any UK mutual funds while you are still a UK resident.

1. Take the UK Tax Break: Use your final months of UK residency to realize gains tax-free (within your UK allowances).

2. Avoid PFICs: By selling these funds before you move, you avoid ever having to file Form 8621.

3. Reset Basis: You can move the cash to the U.S. and invest in U.S.-domiciled ETFs or stocks. These are not PFICs, have much lower management fees, and qualify for favorable U.S. tax rates.

The "Individual Stock" exception

If you are determined to keep your ISA, the only "safe" way to do so is by holding individual company shares (e.g., direct shares in BP, Astra Zeneca, or Apple) rather than funds. Individual shares are generally not subject to the PFIC rules, though you will still owe U.S. tax on the dividends and capital gains.

Conclusion

The ISA is a brilliant tool for someone living in Chelsea or Manchester, but it is a liability for someone living in Chicago or Miami. The lack of U.S. recognition for these accounts means that the very thing that makes them attractive in the UK, the tax-free growth. is exactly what makes them a target for the IRS.

Before you relocate, take the time to audit your UK portfolio. The cost of a few hours of planning today is significantly lower than the cost of a decade of IRS penalties and specialist accounting fees tomorrow.

Our UK Expats in US Series

UK Citizens Moving to the U.S.: Tax Issues to Understand Before You Arrive
ISAs and UK Investments Under U.S. Tax: What Stops Being Tax-Free
Selling UK Property After Moving to the U.S.: Capital Gains and Timing Risks

Disclaimer:
Content published by Antravia is provided for informational purposes only and reflects research, industry analysis, and our professional perspective. It does not constitute legal, tax, or accounting advice. Regulations vary by jurisdiction, and individual circumstances differ. Readers should seek advice from a qualified professional before making decisions that could affect their business.

See also our Disclaimer page