Non-US investor's guide to navigating US tax traps (2024)

See also: Domicile § Domicile of a fund

Warning: Under birthright citizenship it is entirely possible for the US to consider a person who left the US as a baby or small child, or who has perhaps never set foot in the US at all, to still be a US taxable person.^[11]

Once you are a US citizen the only way you can shed this is by renouncing your US citizenship at a US consulate. To do this you would generally need to have another citizenship besides US.

Warning: The process of renouncing US citizenship can itself have damaging US tax consequences, under the US's expatriation tax regime.

Warning: Even if you hold an old and expired green card, unless you took explicit steps to abandon your residency, the US still considers you to be a US lawful permanent resident.^[11] And as a further unpleasant surprise here, when abandoning US residency a long-term green card holder can also be subjected to the US's expatriation tax regime.

The test involves several potentially fiddly calculations, but as a general rule you can usually assume that if you have not set foot in the US in any given year (or perhaps only been there on vacation, and do not hold a US work visa such as H-1B or L-1) then you are not a 'US resident for tax purposes' and the answer is no, and if you have stayed in the US for several months, and especially over six months, and you are not exempt from the substantial presence test (perhaps by holding a US student visa such as F-1 or J-1), then you probably are a 'US resident for tax purposes' and the answer is yes.

Warning: A 'US resident for tax purposes' has all the same onerous US tax and reporting burdens as a green card holder or US citizen.

If you are unsure, try following both paths to get an idea of the challenges of each.

While browsing this part of the IRS web site, perhaps take a look at the actual treaty text for your own country, if for no other reason than to get an idea of how densely written and difficult to understand US income tax treaties are.

There are some surprising holes in the US tax treaty network. For example, there is no treaty with Hong Kong and it is not covered by the treaty with China. And the treaty with Chile was executed in 2010 but as of 2023 has still not been ratified by the US senate, and so has not entered into force.^[13]

US income tax treaties and US estate tax treaties are for the most part entirely separate things. There are many more income tax treaties than there are estate tax treaties.

Canada does not have a separate estate tax treaty with the US. Instead, the US maintains a single treaty with Canada that combines both income taxes and estate taxes. Under this combined treaty, Canadians receive protection up to the level of the US estate tax exemption allowed to US citizens, the same as separate US estate tax treaties for other countries generally provide.^[14]

Your 'domicile generally controls estate tax treaties. Domicile is where your permanent home is, and although it includes residence as one of its elements, residence alone in a country may not be enough to gain you coverage from a US estate tax treaty, so you may need to be particularly careful here. A few US estate tax treaties also cover citizens even when perhaps not resident or domiciled in the treaty partner country,^[15] for example the UK.

Estate tax treaties with some countries contain a 'pro rata unified credit' provision that generally raises the US estate tax exemption to the same level a US citizen gets. Countries with this provision are Australia, Canada, Finland, France, Germany, Greece, Italy, Japan and Switzerland. Countries with 'new' treaties that would generally also raise the US estate tax exemption are Austria, Denmark, Netherlands and UK. Ireland's treaty and South Africa's treaty are both 'old' and may not contain any provisions to raise the US estate tax exemption.

Some treaties have significant holes in them, for example Ireland's and South Africa's may not actually extend the full estate tax exemption for US citizens to Irish and South African investors,^[16] and Switzerland's may not protect from double estate-taxes.^[17]

In general then, finding your country in the list of US estate tax treaties is often just the first step in uncovering whether you are fully protected from US estate taxes. You would need to research thoroughly to be sure that the answer to the question above is really yes. The US estate tax treaties with Canada and the UK are known 'good' treaties.^[18]

With the possible exception of Canada, if your country is not included in the IRS list of US estate tax treaties, the answer is clearly no.^{[note 4]}

Most treaties have a 15% rate on dividends from US stocks. A few have a lower rate, and a few a higher rate. The general US tax rate for dividends paid to investors in countries without a US income tax treaty is 30%.

Warning: US estate tax laws for nonresident aliens can be almost entirely unintuitive and illogical, sometimes to the point of appearing completely random. For example, both directly held US stocks and US domiciled ETFs are subject to the US estate tax, but 'American Depository Receipts' (ADRs)^[20] are not, and neither are some US treasury bond holdings. Similarly, a cash deposit held by a nonresident alien at a US bank is not subject to US estate taxes, but a cash deposit held at a US broker is subject to US estate taxes.^[8]

However, if you want to see the sorts of US tax issues that plague investors who plan to retire outside the US, and those that plague investors based outside the US who are contemplating investing through US domiciled funds and ETFs, feel free to peruse the other flowchart Results sections below.

See also: Taxation as a US person living abroad and US tax pitfalls for a US person living abroad

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,^[1] 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.^[21] This can produce a harsh outcome for mixed-citizenship couples, although the high estate tax exemption allowed to US citizens 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.^[22] 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 you can do 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 these 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.^[23]

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.^[3][4] 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 you report any income or gains from them 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, and while non-US persons can use all of a treaty's benefits, most treaty benefits will be inaccessible to 'US persons' because the US uses a treaty saving clause.

A treaty 'saving clause' allows the US to ignore the treaty where US citizens or residents are concerned. The treaty normally notes a handful of other treaty clauses as exceptions to the 'saving clause', but the general effect of the 'saving clause' is that US persons cannot use large segments of the treaty to mitigate US tax on their income.^{[note 6]}

See also: US tax pitfalls for a non-US person moving to the US

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,^[24] no matter what investments you hold inside it. Because the US estate tax exemption for nonresident aliens is so pitifully low, $60,000, it can catch even modestly sized US pensions.^[8]

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 new country treats your US pension as an unwrapped investment account. 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 1040-NR tax return and taxed at graduated US rates, or partially 'effectively connected' (ECI) and partially 30% taxable as 'fixed, determinable, annual or periodic' (FDAP).^[25] 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 1040-NR 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 carefully consider 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.^[23] This can produce some horrific tax results, and ones that are sometimes unavoidable where that country's pension tax laws do not allow 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. In some countries there are tax-mitigating wrapper accounts which are not strictly pensions, but which you might be able to use as an alternative to a pension. However, because the US does not recognise these account types as tax deferred (that is, as pensions), 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, 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.^[26][27] 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,^[28] even though this potentially violates the Vienna Convention on the Law of Treaties.^[29]

See also: Nonresident alien taxation and Nonresident alien investors and Ireland domiciled ETFs

Reducing or eliminating the US dividend tax trap

If you invest 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 your ETFs hold, and down to 0% US rate on the non-US stocks your ETFs hold.

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.^[10]

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.^[2] 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.

You can buy most popular non-US domiciled ETFs 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.^[8]

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 advantage.

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

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. If your country does this, holding 'accumulating' ETFs effectively transforms your dividends into capital gains for a tax advantage.

See also: Nonresident alien taxation

In this case, depending on how local taxes operate (in particular, credits for US taxes paid) you may find that using US domiciled funds or ETFs is preferable to Ireland or other EU domiciled ones. You do however need to check your situation carefully. It is not often that US domiciled funds or ETFs are the most tax-efficient option for investors based outside the US.

See also: Nonresident alien taxation and Nonresident alien investors and Ireland domiciled ETFs

If you are a US nonresident alien with poor or no US tax treaty coverage, and you will never hold more than $60,000 in US situated assets,^[19] 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.^{[note 7]} 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; and 30% if you have no treaty coverage), but if you can claim that 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.^[10] 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.^[10]

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 circ*mstances.

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.^{[note 8]}

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

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

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. If your country does this, holding 'accumulating' ETFs effectively transforms your dividends into capital gains for a tax advantage.