United States taxpayers who live abroad (US citizens and green card holders) have limited options to save for retirement in a tax-efficient manner. Without employer-sponsored retirement plans, US taxpayers often only have the option of choosing between a traditional IRA (Individual Retirement Account) or a Roth IRA. Because the rules are complex and are based upon income limits, tax-filing status, exclusions and deductions, some US taxpayers abroad don’t take advantage of these tax-efficient investments.
Traditional IRA or a Roth IRA?
A traditional IRA generally allows US taxpayers to contribute and take a corresponding tax deduction. Investments in a traditional IRA account grow tax-deferred until retirement then are withdrawn as taxable income.
A Roth IRA is the opposite of a traditional IRA. US taxpayers contribute after-tax dollars and do not take a corresponding tax deduction. Investments in a Roth IRA account grow tax-free and distributions are withdrawn as tax-free income. Unlike traditional IRAs, there are upper income limits based upon tax-filing status so it may be impossible to contribute directly to a Roth IRA.
Factors such as current age, income, other retirement accounts and retirement location (US or abroad) are important considerations when deciding between a traditional IRA or a Roth IRA.
What’s a Roth conversion?
It may also be possible to do Roth conversions, exchanging taxable retirement income for tax-free retirement income. A Roth conversion refers to the process of converting a traditional IRA account into a Roth IRA account. A Roth IRA may be appealing for the following reasons (to name a few):
- there isn’t a required minimum distribution age;
- the account can continue to grow tax-free for the remainder of your life;
- tax rates may be higher in the future than now;
- you are in a low tax jurisdiction now;
- the country in which you want to retire recognises the tax-free nature of a Roth IRA; or,
- you want to pass assets tax-free to your family.
While a Roth conversion may be a great option for some, it can be a costly mistake for others. There are a few things to understand before converting your traditional IRA into a Roth IRA account.
How long until your retirement?
If you’re retiring within the next few years, a Roth conversion may not be a good option. The money converted into a Roth IRA must stay there for a five-year holding period. If withdrawals are made before the five years, you could potentially pay a 10 percent penalty and/or additional income taxes.
Tax obligations upon conversion
When considering a Roth conversion, you need to understand the tax implications associated with the conversion. Consult with Avrio Wealth or a US expat tax professional before making a final decision; the rules for US taxpayers abroad are not the same as US-based residents.
Roth conversions could push you into a higher tax bracket. While it’s possible to cover the tax using a portion of the distribution itself, this is typically not advised for two reasons:
- you’d be spending some of your future retirement income; and,
- you may be subject to a 10 percent penalty for taking the funds.
Future tax bracket
One of the main reasons an individual chooses to do a Roth conversion is for the advantage of tax-free withdrawals in retirement. With that in mind, take into consideration whether your tax bracket will be higher or lower in the future when you anticipate withdrawing the funds and where you plan to retire. If you believe you’ll be in a higher tax bracket come retirement, it may be worth doing a Roth IRA conversion.
How much to convert and when
If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you do have the option to convert a portion at a time. By spreading the conversion across several years (as opposed to one lump sum), you can lower your yearly tax obligation.
US taxpayers abroad may be able contribute to a traditional or Roth IRA or strategically execute Roth conversions. However, you must understand how the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion (FHE) can affect your decisions on how to save for your retirement in the most tax-efficient manner.
Traditional IRAs, Roth IRAs and Roth conversions may help you achieve your financial goals; however, it’s important to seek advice from your CFP professional or other trusted advisors.
For information on how to optimize your retirement income, contact Ann Marie Regal, CFP® at firstname.lastname@example.org.