Non-US investor's guide to navigating US tax traps

US tax laws contain multiple traps for unwary investors based outside the US and for non-US citizens living in the US. US nonresident aliens, US citizens or green card holders living outside the US, and non-US citizens living temporarily in the US are all at risk. In the worst cases these traps can lead to outcomes such as US income tax rates of 100% on gains, loss of 40% of total assets to US estate taxes, and huge fines for non-disclosure of assets.

 offers guidelines for investors based outside the US who might plan to use index funds or exchange-traded funds (ETFs), with the aim of helping these investors to avoid falling into US tax traps by navigating around, through, or between them. It also outlines some of the investing issues that arise from moving either into or out of the US, and aims to help investors who are now, or plan to become, non-US citizens living in the US, to avoid the worst of the US tax traps that arise when beginning or terminating US tax residence.

Introduction
US tax laws are extensive, intrusive, complicated, and far-reaching, for both US investors and non-US investors.

In common with many countries, the US taxes the worldwide income of its residents. However, it is virtually unique in taxing the foreign income of its citizens and lawful permanent residents who live outside the country either temporarily or permanently.

It also applies onerous estate taxes to US situated assets held by non-US persons (that is, non-US citizens who are also not US residents, referred to in IRS documents and US tax laws and regulations as 'nonresident aliens').

Investors based outside the US and susceptible to hidden US tax traps fall into three main categories: All three groups face significant difficulties with US taxes. By following the guidelines below these investors should be able to avoid the worst of the issues presented by US taxes. If you fall into any of these groups, read on.
 * Nonresident aliens living outside the US and holding US investments or assets
 * US citizens and green card holders living outside the US
 * Non-US citizens living temporarily in the US on a nonimmigrant work visa (such as H-1B or L-1) or a green card

Why fund domicile matters
Just like a person, a fund or ETF has a domicile. This is the country in which the fund's holding company is legally incorporated, and typically where the administration and management of the fund itself takes place.

For example, Vanguard offers two separate S&P 500 index tracker ETFs, and they have different domiciles: Both of these ETFs hold the same underlying stocks, and so the return to investors from them should be the exact same (excluding perhaps a tiny offset due to any small difference in annual charges). So why do Vanguard do this? Surely an investor could choose either at will and get the same results?
 * VOO, provided by Vanguard US, domiciled in the US and traded on US exchanges
 * VUSD, provided by Vanguard in Europe, domiciled in Ireland and traded on the London Stock Exchange and other European exchanges

The answer is US taxes. Despite investing in identical underlying assets -- that is, not just asset class, but actual assets -- investors in varying personal 'tax circumstances' will get different results depending on which of these two ETFs they choose to hold. Sometimes wildly different.

For a US resident, US citizen or green card holder investing in the S&P 500 through VOO, the US will not withhold any tax on dividends, and the individual investor is responsible for their own tax payments to the US. If this person invested in the S&P 500 through VUSD instead, the US would apply a punitive 'offshore fund' tax regime on the ETF returns that in some cases could reduce the overall gain to nothing.

For a nonresident alien or non-US person investing in the S&P 500 through VOO, the US will withhold up to 30% tax on dividends (the actual rate might be reduced by a tax treaty, typically to 15%), and will levy an estate tax of between 26% and up to 40% on the balance on the holder's death (again, depending on treaty). If this person invested in the S&P 500 through VUSD instead, the fund pays 15% internally to the US on dividends but the investor receives all of the remaining 85%, and there is no risk of US or Irish estate tax.

Worse, where an ETF holds no US stocks, the US tax treatment is the same as shown above. For nonresident aliens, this creates an even greater advantage for ETFs domiciled in Ireland over those domiciled in the US. The US dividend tax for a nonresident alien investing through a US domiciled ETF holding non-US stocks is again 30% (or lower, if there is a treaty), and with a risk of 26% to 40% US estate tax on the balance (depending on treaty). For an Ireland domiciled ETF with identical holdings the US dividend tax loss is 0%, so that the investor receives the full 100% of dividends, and with no risk of US or Irish estate tax.

For all of the above cases, whether or not the investments are held inside a pension or other tax-mitigating wrapper may create further significant differences to the tax results. And for investors who have or plan an international lifestyle, moving into or out of the US can create large and damaging discontinuities in tax treatment.

Between the extremes lies a whole spectrum of outcomes. For non-US investors, the decision flowchart below aims to help you uncover where you fall on this spectrum, as a way to guide non-US investors on the decision of whether to hold your investments through the usual Vanguard ETFs discussed by and used by US investors, or whether to hold them through different ETFs -- specifically, non-US domiciled ones. For investors with an international lifestyle and who are currently or who may become US tax residents, or who plan to end US residency, it aims to help chart a route through the maze of US tax traps that you will face.

Decision flowchart
This is the flowchart we will be using to navigate around US tax traps. Scroll down to Start to begin the process of following it.



Start
Navigate the flowchart by answering a series of questions and then following the links that apply to you until you reach a result. Most questions have simple yes/no answers.

Often you will need to read external documents to decide which answer to a question is the right one for you. But by following it, this flowchart should help you to determine how best to invest in index funds or ETFs while minimising US tax difficulties.

The results of using this process are guidelines, not rigid rules. Local factors or conditions may mean that even though it suggests that you use one ETF domicile, it is better somehow, perhaps for reasons of liquidity, spread, or practical access to ETFs, to use another. If this is the case for you, at least after following it you will know the potential pitfalls of the route you choose to take.

Go to Question 1 to begin.

Q1. Are you a US citizen?
If yes, go to Question 3. If no, go to Question 2.

Q2. Are you a green card holder (US lawful permanent resident)?
If yes, go to Question 3. If no, go to Question 3b.

Q3. Are you a US resident?
If yes and you are a US citizen, go to Result A1. If yes and you are not a US citizen, go to Question 4. If no, go to Result A2.

Q3b. Are you a US tax resident?
If yes, go to Question 5. If no, go to Question 6.

Q4. Do you plan to retire in the US?
If yes, go to Result A1. If no, go to Result A3.

Q5. Do you plan to get a green card?
If yes, go to Question 4. If no, go to Result A3.

Q6. Does your country have an income tax treaty with the US?
If yes, go to Question 7. If no, go to Result A4.

Q7. Does your country have an estate tax treaty with the US?
If yes, go to Question 8. If no, go to Question 9.

Q8. What is the US dividend tax treaty rate for your country?
If below 15%, go to Result A5. If 15%, go to Result A6. Otherwise, for above 15% go to Result A4.

Q9. Will you hold more than $60,000 in US situated assets?
If yes, go to Result A4. If no, go to Result A6.

For holdings below $60,000, see also the results from following Question 8.

Results
Following the flowchart interview will guide you one or more of the Results sections below.

You can of course read others for interest or entertainment, but the one or ones that the flowchart guides you to are the only Results that are relevant to your own circumstances and which you should consider applying to your own investing.

A1. This chart does not apply to you
You are a US resident US citizen or green card holder fully intending to retire in the US.

A2. Avoid non-US domiciled funds and ETFs
You are tax-resident outside the US, but at the same time the US claims you as a 'US person'. Or, you are tax-resident inside the US, but still hold investments in a country you lived in previously.

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 * If you live outside the US, unless your country of residence does not levy any income taxes, your income is fully taxable to potentially several conflicting tax regimes at the same time. The intersection of multiple incoherent tax regimes is a deeply uncomfortable position for any investor.

If you live inside the US, any investments you hold in countries you lived in previously may be at risk from punitive US 'anti-offshore' tax laws.

Avoiding the US PFIC tax trap

 * Warning: This is a major US tax trap, and one that you should try your utmost to avoid.

Your major problem when investing will be the US's PFIC tax regime. This draconian law punishes holdings of non-US domiciled funds and ETFs with heavy taxes that can, if left long enough, rise to consume 100% of your gains, something you would want to avoid at all costs. For you then, the most obvious way to defuse this problem is to use only US domiciled funds and ETFs for your index tracker investing.

Unfortunately, this is not always possible. Your home or former country may well have its own 'anti-offshore funds' rules, similar to the US PFIC rules (although unlikely to be anything like as unpalatable), and these would capture any US domiciled funds or ETFs you hold. Worse still, US domiciled funds and ETFs could well be entirely unavailable to you where non-US brokers do not offer them and US brokers refuse service to investors who are not US residents (even if they are US citizens).

If you are stuck in this way, your main other option is to invest through individual stocks. These escape PFIC and other 'anti-offshore funds' rules. You may be able to hold PFIC funds inside of foreign pensions and so avoid the worst of the US PFIC tax treatment, but then the US rules on foreign pensions can themselves be punitive where these pensions are not protected by treaty (and indeed, many treaties do not cover pensions at all well).

Failing this, if you live outside the US and have a non-US person spouse you might consider letting them do all the investing for the pair of you. They will have to be careful as nonresident alien investors themselves to avoid the multitude of US tax traps, but at least they will be free and clear of US PFIC tax difficulties.

Avoiding the US estate and gift tax trap
There is no unlimited marital exemption for US estate and gift taxes where the recipient spouse is not a US citizen. This can produce a harsh outcome for mixed-citizenship couples, although the high estate tax exemption allowed to US citizen usually makes this a non-issue. When gifting to a non-US citizen spouse though, care should be taken to fill out the appropriate gift tax return where the gift exceeds the US annual gift allowance for non-US citizen spouses.

Beyond the estate and gift tax exemptions a 'QDOT' trust is one possible way to defer the US tax bite on gifts and bequests to a non-US citizen spouse. It is important to note that a QDOT does not reduce or avoid a harsh US estate tax, but only defers it.

Avoiding US tax traps on a non-US pension
A few treaties provide for non-US pensions to be treated for US tax in a way approximately equivalent to US pensions. For those that do not, and for non-treaty countries, a local pension can quickly become a US tax nightmare.

Symmetrically, many countries do not recognise US pensions as tax deferred, meaning that holding one while living in that country can become another tax nightmare. How much of a nightmare depends on any treaty and the local tax laws for 'offshore' accounts.

In practice, there is often little that can be done to neuter this tax trap. Many countries do not permit any early access to pension funds, meaning that you could have to deal with tax fallout from such accounts for perhaps many decades.

Avoiding US tax traps on a non-US tax-free investment wrapper
The US generally does not recognise any other country's tax-free wrapper accounts. The result is that anything you hold in those is fully taxable to the US under normal rules, including PFIC treatments and potentially complex trust tax reporting.

Examples include UK Individual Savings Accounts (ISA), Canadian Tax-Free Savings Accounts (TFSA), Japanese NISA accounts, and French Assurance-vie and Plan d'Épargne en Actions accounts. These are entirely tax-free to local country residents who are not US persons, but fully taxed by the US if you are a US citizen or a green card holder.

Avoiding US "information reporting form" penalty traps
If you hold non-US accounts, and the balance in these accounts exceeds certain thresholds, you may have to file annual reports indicating the existence of, and balances in, these accounts. In some cases, the threshold is relatively low, for example $10,000. And reporting often triggers on the aggregate highest balance in accounts during the year. This means that the same $5,001 transferred between two different accounts triggers reporting, because the aggregate of highest balances for the year is $10,002.

The reporting rules cover nearly all non-US account types, including bank and credit union cash accounts, investment and brokerage accounts, and pensions. There is no additional tax liability from reporting these accounts, because any income or gains from them should be reported elsewhere on your US tax returns. There are however significant penalties for failing to file these reports.

Using US tax treaties
Tax treaties offer a number of tax mitigation benefits, but most of these benefits will be inaccessible to 'US persons' due to the use of a treaty saving clause by the US.

A treaty 'saving clause' allows the US to ignore the treaty where US citizens or residents are concerned. A handful of other treaty clauses are usually noted in the treaty as exceptions to the 'saving clause', but the general effect of the 'saving clause' is that large segments of the treaty are rendered unusable by US persons, meaning that they cannot use them to mitigate US tax on their non-US income.
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A3. Create a relocation-resistant portfolio

 * While a US resident or green card holder, see also Result A2.


 * For an outline of the situation when you are no longer a US resident or green card holder, see also the results of following Question 6 as if you are now resident in your new country.

You are tax-resident in the US, but think you might move or retire outside the US.

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 * International relocation is a huge problem for investors. It can lead to upheaval not just in taxable portfolios, but potentially also in pension and any other tax sheltered or tax deferred wrappers. If possible, you want to build a portfolio that you can hold across international move, but often this simply cannot be done.

Avoiding US and non-US tax traps on a US pension

 * Warning: If you move to a country that lacks a US estate tax treaty with the US, your US pension is at risk from US estate taxes. A US pension is treated as a 'US situated asset' for estate tax purposes, no matter what investments you hold inside it. Because the US estate tax exemption for nonresident aliens is so pitifully low, $60,000, even modestly sized US pensions could be caught by this.

Specifically for pension savings, the first thing to consider could be whether a Roth IRA might be useful to you. If you are moving to a country without an income tax, a Roth will be fine. A few of the US income tax treaties also protect Roth accounts against tax by another country, but these tend to be rare. The most likely case is that you move to a country that will 'look through' the Roth wrapper and tax income from these assets as if the Roth did not exist. In that case, either hold assets inside the Roth that will not be subject to punitive local taxes, or (worst case) collapse the Roth and take the cash to your new country, then invest locally.

If a Roth is not an option, see if you have any treaty coverage for non-Roth US pensions. If not, the worst that usually happens is that your US pension is treated as an unwrapped investment account in your new country. It may be tempting to close the US pension entirely and take the balance as cash, but the US's early withdrawal penalties on pensions can make that an undesirable option. Also, weigh up how much employer contribution is in the pension before deciding.

Whether to save into a 401k or IRA at all can be a tricky decision in itself. Where a US pension will be a tax nightmare once you no longer live in the US, there may be arguments for not using these accounts, or perhaps only participating up to the maximum employer match. To make this decision you will need to compare your employer match with the IRS (and any state) early withdrawal penalty on 401ks and IRAs.

If you draw from a US pension as a nonresident alien, the standard US tax withholding rate is 30% and the income counts as either 'effectively connected' income on a 1040NR tax return and taxed at graduated US rates, or partially 'effectively connected' and partially 30% taxable as 'fixed, determinable, annual or periodic'. Applying these rules can quickly become infuriatingly complicated, and may be impossible due to lack of historical data. However, many tax treaties modify this, for example, for a UK resident, 401k and IRA withdrawals are taxable only to the UK and the US rate is 0%. In this case the 401k or IRA provider should not withhold any tax under the relevant treaty. Unfortunately, some providers are known to ignore this and withhold US tax anyway, meaning that a 1040NR US tax return is required to recover the over-withholding.

Avoiding US tax traps on a non-US pension

 * Warning: This is a major US tax trap, and one that you should try your utmost to avoid.

In tandem with the above, you may also need to consider carefully the US tax implications of holding a non-US pension while you are resident in the US. If you still hold a pension from the 'old country', unless protected by a treaty the US will tax gains within it annually as if it were just another offshore investment account. This can produce some horrific tax results, and ones that are sometimes unavoidable where that country's pension tax laws do not permit any form of early withdrawal.

Double-tax on your pension gains are entirely possible, if the US taxes your pension gains while you are resident but you must again pay local country tax on withdrawals after leaving the US. And you should watch out especially for PFIC issues in such accounts, as well as tiresome and duplicative annual US tax 'information reporting forms' for holding this type of account.

You should also watch out for US tax traps that can apply to non-US accounts that you retained after moving to the US. Some tax-mitigating wrapper accounts can be used as alternatives to a pension in their country of origin, but as the US does not recognise these account types as tax deferred all the usual US tax rules and tax traps will apply to them for US residents. Examples include UK Individual Savings Accounts (ISA), Canadian Tax-Free Savings Accounts (TFSA), Japanese NISA accounts, and French Assurance-vie and Plan d'Épargne en Actions accounts.

Avoiding US taxable account traps
For unwrapped and taxable accounts, check with any applicable US income tax treaty that the investments you hold in it will not be subject to punitive local taxes when you move. Again, some countries either do not levy income taxes or perhaps do not tax investment income. Others are not so benign. In the worst case you can sell to cash and take that with you, although this may generate a US capital gains tax that you would rather avoid.

Avoiding the US expatriation tax trap

 * Warning: This is a major US tax trap, and one that you should try your utmost to avoid.

In all cases you may also need to watch out for the US's expatriation tax if you renounce US citizenship or abandon a green card in order to simplify your tax situation by reducing the number of tax regimes you have to live under from several to just one.

The provisions of the US expatriation tax are draconian, and include immediate taxation of all unrealised capital gains above an exclusion, immediate taxation of retirement savings accounts as if fully withdrawn on the date of expatriation (even though nothing is actually withdrawn, and with no exclusion), and a harsh transfer tax of 40% on gifts and bequests made back to US persons. Double-tax and even triple-tax are possible, and perhaps likely, if you are unfortunate enough to be subject to this tax.

This tax is hard to avoid once you have passed the asset and time limits. One useful method to sidestep it though, is to give away enough assets (even if that means filing US gift tax returns where required) so that you then fall below the asset limit.

Treaties may offer scant protection here. In many ways, the US expatriation tax is written to override existing US tax treaties, even though this potentially violates the Vienna Convention on the Law of Treaties.
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A4. Avoid US domiciled funds and ETFs and prefer Ireland or other non-US offerings
You are a US nonresident alien with poor or nonexistent US tax treaty coverage.

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 * If you hold US domiciled funds or ETFs, you will overpay US taxes on dividends, and you also potentially risk a huge loss to US estate taxes if you have the poor judgement to die while holding them.

Reducing or eliminating the US dividend tax trap
By investing through Ireland domiciled funds or ETFs, you will reduce your US tax liability from as much as 30% for non-treaty countries, down to 15% US rate on dividends from the US stocks held by your ETFs, and down to 0% US rate on non-US stocks held by your ETFs.

This happens because an ETF domiciled in Ireland can use the US/Ireland tax treaty to obtain a 15% rate on US dividends, and whatever the appropriate treaty rate is with Ireland for dividends from other country stocks.

Eliminating the US estate tax trap

 * Warning: This is a major US tax trap, and one that you should try your utmost to avoid.

If you die while holding US situated assets, the US can apply an estate tax of up to 40% of the balance above a $60,000 exemption. However, when you hold ETFs domiciled in Ireland or another non-US domicile, you do not directly hold any US assets. This means that you are now entirely protected from unpleasant US estate tax surprises. The US estate tax cannot 'look through' a fund or ETF to the ultimate individual owner of shares in that fund or ETF.

Most popular non-US domiciled ETFs can be purchased on the London Stock Exchange and the Euronext exchange, so you will need to find a broker that offers the appropriate exchanges. Interactive Brokers is a popular choice for many, but be aware that it is US based. This means that you should avoid holding more than $60,000 in cash at this broker, otherwise US estate taxes again become an issue.

Accumulating (or capitalising) funds
Funds and ETFs that pay out dividends regularly to investors are known as 'distributing' funds. Non-US domiciled funds do not pay out capital gains distributions. And there is a class of non-US domiciled funds and ETFs known as 'accumulating' or 'capitalising'. These funds and ETFs retain all the dividends paid to them by the stocks that they hold, so that their 'net asset value' rises in response.

Different countries treat 'accumulating' ETFs differently, but in some cases this can lead to an investor advantage.

The neutral case is where a country taxes 'notional' dividends annually. That is, it taxes the dividend as if the investor received it, even though they did not (and later allows a reduction for any capital gains taxes). Here an investor holding 'accumulating' ETFs in a taxable account has no tax advantage. There can be a useful extra convenience in holding these inside tax shelters such as pensions, though.

There is a better outcome where a country treats the entire return as a capital gain and where the capital gains tax rate is lower than the rate on dividends. Here, an investor holding 'accumulating' ETFs effectively transforms dividends into capital gains for a tax advantage.
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A5. Consider preferring US domiciled funds and ETFs
You are a US nonresident alien with surprisingly good US tax treaty coverage.

A6. Choose your funds and ETFs for best local tax outcome
You are a US nonresident alien with average US tax treaty coverage. Or, you will never hold more than $60,000 in US situated assets.

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 * If you are a US nonresident alien with average US tax treaty coverage, your own country's US dividend tax rate is equal to that paid by a non-US domiciled ETF. In this case, you can choose your holdings carefully to optimise for local taxes. This requires you to fully understand the tax regime in your own country, especially any 'anti-offshore fund' rules or regulations, but the results can be worthwhile.

If you will never hold more than $60,000 in US situated assets, and your own country's US dividend tax rate is higher than that paid by a non-US domiciled ETF, you may be able to reclaim this US tax directly from your local tax authority so that its overall cost to you is negated.

In both cases, you need to carefully measure your local marginal tax rate on dividend income, so that you can evaluate whether or not a US domiciled ETF makes sense for you. In general, unless your local marginal tax rate is at least as high as your US dividend tax rate and you can claim full foreign tax credits against local tax, US domiciled ETFs would not be useful investments for you and you should prefer Ireland domiciled ETFs.

In 2018, a new EU regulation known as PRIIPs came into force. Because no US domiciled funds currently conform to PRIIPs, it is now difficult or even impossible for EU and UK residents to purchase them. If you are in a country that is covered by PRIIPs, and you cannot work around it, you will need to use non-US domiciled ETFs. Most popular non-US domiciled ETFs can be purchased on the London Stock Exchange and the Euronext exchange.

Funds that track US indexes
For funds or ETFs that track only the S&P 500 or other purely US stock indexes, choosing a US domiciled fund may be a good option. You will pay 15% to the US (or higher, if your treaty rate is above the usual 15% US tax treaty rate), but if that can be claimed against any local tax then you do not lose by choosing a US domiciled fund or ETF.

By comparison, a fund or ETF domiciled in Ireland and tracking the same index would pay 15% to the US on the dividends it receives, and pay the remaining 85% to you. But it is likely that this 85% paid out is now fully taxable to your local country, and with no way of obtaining a credit for the 15% paid internally by the ETF (countries differ on this, so check local details carefully). In this case, if your own US treaty rate is 15% you will pay a higher tax overall on the Ireland domiciled ETF compared with the US domiciled one.

Funds that track non-US indexes
For funds or ETFs that track only non-US stock indexes, there is no gain from using a US domiciled fund except perhaps for the lower fund annual management charge. In this case, you would pay 15% (or higher, depending on treaty) in US tax that is potentially reclaimable against local tax. By comparison, if you held an Ireland domiciled fund tracking the same index, you would suffer no withholding tax but then have to pay full local tax on the entire dividend, for the same end result.

Funds that track global indexes
For global funds, containing a mix of US and non-US stocks, the picture is blurry. Overall you might come out ahead with a US domiciled fund because around 50% of the world's market cap is from US stocks, but the actual outcome is almost entirely impossible to predict with any accuracy.

Accumulating (or capitalising) funds
Funds and ETFs that pay out dividends regularly to investors are known as 'distributing' funds. The US regulations for funds and ETFs require a US domiciled fund to pay dividends to holders at least annually. It must also pay out capital gains realised internally by the fund as distributions to holders under some circumstances.

Non-US domiciled funds do not have this restriction. Non-US domiciled funds do not pay out capital gains distributions. And there is a class of non-US domiciled funds and ETFs known as 'accumulating' or 'capitalising'. These funds and ETFs retain all the dividends paid to them by the stocks that they hold, so that their 'net asset value' rises in response.

Different countries treat 'accumulating' ETFs differently, but in some cases this can lead to an investor advantage.

The neutral case is where a country taxes 'notional' dividends annually. That is, it taxes the dividend as if the investor received it, even though they did not (and later allows a reduction for any capital gains taxes). Here an investor holding 'accumulating' ETFs in a taxable account has no tax advantage. There can be a useful extra convenience in holding these inside tax shelters such as pensions, though.

There is a better outcome where a country treats the entire return as a capital gain and where the capital gains tax rate is lower than the rate on dividends. Here, an investor holding 'accumulating' ETFs effectively transforms dividends into capital gains for a tax advantage.
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