What are ISAs and why do they matter
Individual Savings Accounts (ISAs) are brilliant. Truly brilliant. UK residents can take advantage of compound interest in the most tax-efficient manner; contributing up to £20,000 annually which will subsequently grow free from tax on capital gains, dividends, and interest.
As an American in the UK however, things aren’t nearly as simple.
How the United States view ISAs
Unfortunately, the Internal Revenue Service (IRS) doesn’t recognize ISAs as tax-advantaged. To the IRS, an ISA is just another foreign financial account. Any interest, dividends, or gains earned inside an ISA must be reported on your US tax return, and you’ll be taxed accordingly.
That means interest from a Cash ISA is taxable, as well as dividends and capital gains from a Stocks and Shares ISA.
There’s no “special” treatment for ISAs under the US-UK tax treaty. Americans can’t “defer” tax on ISAs like they might with a 401(k) or IRA in the States.
Passive foreign investment companies (PFICs) and ISA holdings
Many Americans with a Stocks and Shares ISA invest in UK mutual funds or foreign ETFs. Here’s the catch: these often fall under the IRS’s definition of a Passive Foreign Investment Company (PFIC).
PFICs are taxed harshly:
- Gains are subject to the highest US tax rates.
- There’s a complicated and punitive interest charge on gains.
- Filing involves extra forms (Form 8621), which can be tedious and expensive if you use a tax preparer.
Unless you elect certain IRS treatments (like “mark-to-market” or “qualified electing fund” status), investing in non-US funds can lead to tax bills far worse than simply investing in US-based mutual funds.
The natural alternative in my opinion are direct equity holdings. But more on that later.
How to report ISA holdings on your U.S. taxes
If you’re a US citizen, you must report:
- Income from the ISA on your Form 1040, Schedule B (for interest and dividends) and Schedule D (for capital gains).
- PFIC investments on Form 8621 if applicable.
- Foreign accounts exceeding $10,000 (in aggregate) at any point during the year on the FBAR (FinCEN Form 114).
- Foreign financial assets over certain thresholds on FATCA Form 8938.
Even if your ISA balance is modest, you’re likely required to file an FBAR if the total value of all your foreign accounts crosses $10,000, even for a day. Penalties for missing FBAR or FATCA filings are severe, so it’s critical to stay compliant.
So why should an American use an ISA?
A use-case is a specific situation in which a solution could potentially be used. As financial advisers we’re constantly developing our library of solutions because there are no one-size-fits-all policies.
Any American living in the UK will be aware of the salary differences between here and home. The average US salary is roughly £50,000 (fluctuating based on exchange rates) compared to £37,430 in the UK. I’m not bringing this up to rub salt in open wounds, rather to point towards the base levels that tax policies are set around.
Securities held for over a year qualify for a reduced Long-Term Capital Gains rate in the US.
In 2024 (for filing in 2025) the Long-Term Capital Gains Tax (LTCGT) Rates for a single-filer were:
- 0% up to $47,025 in taxable income.
- 15% from $47,026 to $518,900 in taxable income.
- 20% above $518,900 in taxable income.
For reference, the UK basic-rate capital gains tax is 18% and 24% for higher and additional rate payers. An annual income of £201,000 would put you in the top 1% of UK tax payers, but still short of the highest LTCGT rate from above (according to UK Government data from the 22/23 tax year).
Therefore in practice, very few UK earners would ever trigger the highest US LTCGT rates. While a non-US citizen can use an ISA completely free from CGT, an American citizen in the UK can still potentially use an ISA to pay a lower CGT rate than they otherwise would if they opted to use a general investment account.
Final word
- ISAs are much less useful for Americans than they are for other UK residents.
- There are still marginal advantages to using an ISA as an American tax payer if done correctly (avoid PFIC by investing in direct equities and holding them for longer than one year to benefit from the LTCGT rates).
Obviously implementing a high-quality and diversified direct equity portfolio is more complicated than using passive options that track an index or market. This is certainly worth considering before investing. Investing in equities comes with volatility and your capital is at risk. For more information on portfolios like the one mentioned above, please visit pwmsolutions.co.uk.
While ISAs offer major tax perks for UK citizens, Americans living in the UK don’t get the same benefits. ISAs can be an important component of your financial future, even as an American, but they’ll require intentional investment decisions and diligent tax reporting.
When in doubt, consult a tax advisor and/or financial adviser experienced in cross-border issues—this is one area where DIY can get costly fast.
