Roth Conversions
“In this world nothing can be said to be certain, except death and taxes."
– Benjamin Franklin
Many or our clients living overseas have previous 401(k) plans, Rollover IRAs, or IRAs they are contributing to annually.
While overseas, depending on where you live, there is a unique opportunity to maximize your tax-free money by converting pre-tax accounts to tax-free Roths. This works particularly well if you are living in a low-tax jurisdiction like Singapore—doing this in a country like Australia or the UK would likely not make sense.
What is a Roth Conversion?
This is a process of transferring your pre-tax assets into a tax-free account. You’d realize income (and potentially income tax) in the year of transfer, but then these funds would grow tax-free and be tax-free upon distribution (depending which country you live in).
For example, if there is $100k in your Traditional IRA and you transfer this amount directly into your Roth IRA, it would be considered $100k of income this year but then the funds grow tax-free afterwards. Assuming this grows for the next 30 years at a 7% per year rate of return, the ending balance would be ~$760k—all of which could be withdrawn without owing US tax. If the conversion did not occur, all this ~$760k would be taxable upon distribution in the future.
Why do Roth Conversions when abroad?
When living in a low-tax country overseas, you likely are not paying state income tax nor FICA tax. This puts you at a lower overall tax rate than if you were living in the US, particularly in states like New York or California. Upon returning to the US, this may no longer be applicable, and future distributions could be taxed at a higher overall rate.
Furthermore, future tax rates are unknown. Meaning that even though you might be in a high federal tax rate due to work earnings, tax rates are not stagnant and, in the future, they may increase. Comparing US tax rates to many countries in Europe, the US federal rate is quite low (e.g., in the UK, the 45% rate starts at USD ~$168k of income; in the US, the maximum federal rate of 37% starts at USD ~$626k of income).
Also, for those with a non-US spouse, converting can be even more beneficial given that it is difficult to open an Inherited IRA for a non-US person and many custodians will not allow this. If an account is not opened, then the funds could be withdrawn all at once but that might lead to a large tax bill in one year. If a Roth IRA is inherited, all funds can be withdrawn at once without tax US consequences.
Lastly, if a non-spouse inherits an IRA, all funds must typically be withdrawn within 10-years. This can cause a large tax liability for beneficiaries, particularly if it is a sizable account and the recipients are in their peak earning years. Converting an IRA can enable more wealth to be passed to the next generation.
Why not do Roth Conversions when abroad?
It is also important to consider the counter point before diving into this strategy. One reason to avoid it is if your tax rate is truly going to be lower in retirement than it is now. To a degree, this is unknowable due to the above point—tax rates change. In this sense, it could be beneficial to hedge your risks by having some funds in pre-tax accounts and other funds in tax-free accounts to have tax type diversity. Then you can select which buckets to withdraw from during retirement to mitigate your tax bill.
Another reason to not do a conversion is if you plan on living in a country that does not recognize the tax-free nature of Roth IRAs. This includes Germany, Australia, and several other countries. The Roth IRA is relatively new, beginning in 1998, and with many tax treaties being 50+ years old, they might not mention this type of account in the agreement. So, if you plan to live abroad indefinitely, ensure you will not be double-taxed on these funds.
Conclusion
As you plan your long-term financial future, it is important to consider not only the investments you own, but also the type of account they are owned within. Sometimes, increasing your tax-free bucket can be beneficial and improve the success of achieving your financial goals. The conversion process does not have to occur all at once; rather, it can be achieved overtime to optimize your annual taxes.
Overall, it is important to have a clear plan in place for your investments and tax types, and an understanding of why this plan makes sense for you and your family.
For more information on how to optimize your cross-border personal finances, please reach out to one of our wealth planners.
This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/ and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at info@avriowealth.com.