As an American living and working abroad you better be fully armed with a knowledge regarding IRA for US expats, its’ opportunities and tax savings you can achieve. For example, do you know that depending on your foreign income you may or may not contribute to your regular or Roth IRA as an American abroad?
A lot of US expats qualify for the Foreign Earned Income Exclusion and they choose it to exclude the first $102,100 (as of the 2017 tax year) of foreign wages or self-employed income from the US federal income taxes. But not so many people know that if you are using the Foreign Earned Income Exclusion, then you signed yourself to its restrictions on your contributions to an IRA. Read further to find out more about it.
What Is The Difference Between Traditional IRA And ROTH IRA?
It’s important to understand the difference between Traditional IRA and Roth IRA before we go deep into details of correct coordination of IRAs and the Foreign Earned Income Exclusion. As we know, US workers are accustomed to saving for retirement by contributing to either a traditional or a Roth IRA.
First of all, you need to know that as an employed American abroad, in most cases you are limited to an ability to contribute only to a traditional or ROTH IRA. If you have a foreign employer, you may not have the chance to use a 401(k) or SIMPLE IRA option as these are set up within US borders.
The main difference between Traditional and Roth IRAs is when you pay income taxes on the money you put in the plans. A traditional IRA taxes you on your money in the future, when you withdraw the money in retirements. With a Roth IRA, it’s the exact opposite – you pay taxes on your funds now.
Tax Tip 1: A Roth IRA may be a better option for younger US expats at the beginning of their professional career because your tax rate might be lower than in the future.
Tax Tip 2: Self-employed individuals or owners of a small business have several options. You can choose to contribute to an individual IRA or set up a retirement account for your company. By having SIMPLE IRA or Self-employed Plan (SEP), you could contribute as an employee in addition to an additional ‘employer’ amount.
Tax Tip 3: Contributing to a Traditional IRA will greatly benefit those who invest their money at the peak of their earning potential (at the highest tax rate). Why is it a good option? It is due to a tax break now since you will not pay taxes at the highest.
Amount Of Roth IRA Contributions That You Can Make For 2018
|If your filing status is…||And your modified Adjusted Gross Income is…||Then you can contribute…|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||< $120,000||up to the limit|
|> $120,000 but < $135,000||a reduced amount|
|married filing jointly or qualifying widow(er)||< $186,000||up to the limit|
|> $186,000 but < $196,000||a reduced amount|
|married filing separately and you lived with your spouse at any time during the year||< $10,000||a reduced amount|
Choosing Between Traditional IRA vs. ROTH IRA
Why choose the ROTH? If you expect higher taxes in retirement, a ROTH IRA might be best. If in future you will most likely move to higher tax rates, you won’t owe the IRS money when you start drawing income as withdrawals from a ROTH IRA are tax-free.
Why choose a Traditional? Due to full- or semi-retirement, those who earn high wages expect to be in a lower tax bracket when they retire. By deducting your contributions now, you lower your current tax bill.
How will your IRA withdrawals be taxed in retirement? If you are 59 ½ or older and your account is at least 5 years old, then you will be able to withdraw from a ROTH IRA tax-free. When it comes to withdrawals from traditional IRAs, they are taxed as a regular income and based on a tax bracket for the year in which you are making the withdrawal.
IRAs For US Expats And The Foreign Earned Income Exclusion
Americans abroad may be eligible to use the Foreign Earned Income Exclusion and/or the Foreign Housing Exclusion. But before claiming any of these exclusions, you need to be aware of the effect of excluded income on IRAs:
- If you exclude all of your income and have no other sources of earned income, you are not eligible to contribute to an IRA
- If you only exclude part of your income or claim the foreign tax credit instead, you may still be able to contribute to an IRA
So it really means that you may be able to contribute to a qualified retirement plan in cases when your income is greater than the FEIE.
Working Out FEIE And IRAs
You need to be aware that for ROTH IRA purposes, your adjusted gross income is modified to add back any foreign earned income exclusion and/or foreign housing expulsion that you have claimed. It leads to a really narrow range of income possibilities for US citizens living overseas to fund a ROTH IRA. For example, if you are a single filer who is claiming the full $102,100 FEIE for 2017 tax return, then you would have to earn over $102,100 and have modified AGI not more than $133,000 to be able to contribute funds to a ROTH IRA.
In cases of Traditional IRAs, the Foreign Earned Income Exclusion works in 2 different ways:
- Just like with the ROTH IRA, a taxpayer cannot contribute excluded income to a traditional IRA.
- A deduction for a traditional IRA contribution might be limited or eliminated completes if you are covered by your employer’s retirement plan.
In latter case, you cannot participate in a group retirement plan and a traditional IRA would be available for you only on foreign wages or net self-employed income in cases of the FEIE amount.
Using The Foreign Tax Credit
In many cases claiming Foreign Tax Credit is more beneficial and brings more advantageous results than the Foreign Earned Income Exclusion. We even have an infographic here explaining why it is better to choose FTC over FEIE.
Do you know that by claiming the Foreign Tax Credit, you are going to have taxable wages or net self-employment income that will give you an opportunity to an IRA in the U.S.? Foreign Tax Credit also provides a tax reduction in the U.S. based on tax amount paid to the country where you work/reside. Thus this income is not excluded and you will have an opportunity to receive the full benefit of contributing it to an IRA.
5 Things To Sum Up About IRAs For US Expats
As an American abroad, who wants to have full tax advantages of contributing to IRAs for US expats, you need to remember following:
- Most Americans overseas qualify for traditional or ROTH IRAs only. The main difference between these two is when you pay income taxes on the money you put in the plans.
- While younger US expats who are at the start of their career may benefit from choosing ROTH IRA, the traditional IRA is a better option for those Americans who are at the peak of their career and invest their money at the top of their earning potential (at the highest tax rate).
- When you use Foreign Earned Income Exclusion and Roth IRA, you are limited to a narrow range of possibilities. It’s due to the fact that for Roth IRA purposes your adjusted gross income is modified to add back any foreign earned income exclusion and/or foreign housing expulsion that you have claimed.
- Speaking of a traditional IRA and Foreign Earned Income Exclusion, you as a taxpayer cannot contribute excluded income to a traditional IRA. And a deduction for a traditional IRA contribution might be limited or eliminated completely in cases when you are covered by your employer’s retirement plan.
- Choosing Foreign Tax Credit can be more beneficial for you as your income is not excluded and you will have taxable wages and net self-employment income leading to a chance to contribute to an IRA in the US and receive full benefits of such.
Have questions? Contact Olivier Wagner.