U.S. Retirement Accounts
IRAs, 401(k)s, Roth IRAs, Individual 401(k)s, 403(b)s, deferred compensation plans and defined benefit employer pension plans are some of the many possible investment choices from which American taxpayers might choose.
Each has slightly different tax implications and a separate set of complex compliance rules, contribution restrictions, mandatory withdrawal requirements and other features. U.S. Citizens in Spain should keep in mind that for the Spanish Law all these plans do not meet the requirements to be Pension Plans in Spain and they are considered regular saving accounts from the tax point of view.
The good news is that Americans abroad generally have the same opportunities as Americans at home when it comes to accruing tax benefits from tax-advantaged retirement accounts. In fact, under certain circumstances and with proper planning, U.S. expats may be able to manage their foreign residency to gain unique advantages.
So while there are additional factors to consider, there are many ways American expats can benefit from employing retirement accounts and managing their investments as an U.S. expat.
Understanding the Difference between a Traditional IRA and a Roth IRA
Many investors are familiar with the concept of the individual retirement account (IRA), commonly referred to as a “traditional IRA.” These accounts allow taxpayers to contribute up to $6,000 of their earned income each year ($7,000 if over age 50, for 2022) and receive a corresponding tax deduction (similar tax-deferred employer sponsored retirement plans, such as 401(k)s, have higher contribution limits).
Therefore, a taxpayer in the 22% marginal tax bracket will get the immediate benefit of saving $1,320 on their current year tax bill ($6,000 x 0.22) if he or she makes the maximum contribution to a traditional IRA. Investments in an IRA account grow tax-deferred until retirement. At age 59 and a half, distributions can begin. Distributions are, in most cases, 100% taxable at the owner’s marginal tax rate.
Furthermore, starting at age 72, minimum annual distributions (also known required minimum distributions, or RMDs) based on the account owner’s life expectancy become mandatory. In addition to annual contributions, traditional IRA accounts may also be funded by the rollover of an employer plan. These include plans such as 401(k)s, profit sharing plans and 403(b)s.
Where the investor has assets in such a plan but is no longer participating, rolling the assets into a traditional IRA is free of tax. This is typically referred to as a 401(k) rollover.
American expats are eligible for 401(k) rollovers just as any other eligible person is. However, restrictions apply that may prevent contributions from being made. Contribution amounts cannot exceed the actual amount of earned income. Individuals covered by a qualified company retirement plan may be partially or completely prevented from contributing pretax dollars to an IRA.
Special Expat Considerations for Retirement Accounts
American citizens not resident in the U.S. may contribute to an IRA. However, they must have earned income that is not excluded by the foreign earned income exclusion (FEIE) and the foreign housing exclusion (FHE). For example, an American citizen employed abroad by a foreign corporation and earning $85,000 a year who is able to exclude all his or her income from U.S. taxation under the FEIE will have no “non-excluded” income from which to make an IRA contribution and therefore cannot contribute.
A higher-income expat with $202,000 of earned income who applies a combination of the FEIE and FHE or foreign tax credits to reduce their U.S. tax liability will be able to make a contribution. Of course, if the combination has eliminated all U.S. tax liability, a traditional IRA contribution will provide no immediate tax benefit and would be taxed when withdrawn in retirement.
Thus, we conclude that, generally, IRA contributions (if allowed) may make sense in countries of residence with low tax rates but not in those with high tax rates like Spain or any other European country. Make sure you understand U.S. retirement contribution rules when you have foreign earned income. Even if a traditional IRA isn’t permitted or doesn’t make financial sense, a Roth contribution might make sense for expats.
How Do Roth IRA Accounts Work?
Contributions to Roth accounts are not tax-deductible in the year of the contribution, meaning they don’t provide an immediate tax benefit. In contrast, contributions to other traditional retirement accounts (e.g., 401(k)s and IRAs) reduce taxable income by the amount of the contribution for the year the contribution is made, hence providing an immediate tax benefit. It’s important to remember, however, that this tax benefit offered by traditional accounts is merely a deferral of the tax: when the accounts are drawn down in retirement, all withdrawals are fully taxable.
Advantages of Roth IRAs for Expats
The benefit of Roth accounts is that earnings (e.g., interest, dividends and capital gains) are not taxed when withdrawn. So these earnings are tax-free, not just tax-deferred and qualified distributions are tax-exempt. Therefore, when choosing a Roth over a traditional retirement account, the effective tradeoff is to give up tax deferral on contributions and earnings in favor of tax-exemption of investment income.
So, what’s the more valuable tax benefit: tax deferral on the whole account or tax exemption on investment income? The right answer depends on many variables, but there is a simple rule of thumb: consider Roth if you expect your tax rate in retirement to be as high as or higher than your current tax rate.
Roth contributions and Roth conversions make sound financial sense for expats when tax rates in retirement are expected to be as high as or higher than they are now. To simplify matters, we ignored state taxes because the state tax rate presumably applies at the time of contribution as well as in retirement.
Can Expats Contribute to an IRA? Key Questions to Consider
Expats need to exercise caution when contributing to Roth IRAs, as the tax implications could be different depending on which country you currently live in. See the video below for more detail answering the questions:
In the end, the best decision for you and your family will depend on a thorough analysis of your financial circumstances — especially the many factors that apply uniquely to American expats.