Posted by Shane Mason, CPA
The United States has one of the most unique tax systems in the world when it comes to the taxation of its citizens abroad. While most countries only tax income based on residency, the United States is the only nation that will tax you based on your citizenship. In other words, if you are a U.S. citizen, all of your income is subject to U.S. tax regardless of where it was earned. If you’re an expatriate reading this, you’re already all too familiar with this issue. If you want to help change these rules, the American Citizens Abroad organization is worth looking into.
Ok, so U.S. citizens earning money overseas are subject to special tax rules. What tax breaks are available to them? The foreign tax credit is a great tool for reducing your U.S. tax bill for each dollar that you pay in foreign tax. That’s easy to comprehend, but sometimes very difficult to calculate, and it’s not the focus of this article today, so we’ll visit that another time.
The second major form of tax relief for expatriates codified under §911 of the Internal Revenue Code is commonly referred to as the foreign earned income exclusion, hereafter referred to as FEIE (I personally add an R after the F in the my mind to pronounce it FREIE as in tax free). It allows an expat to exclude the first $101,300 of their foreign earned income from US taxation. To repeat, your first $101,300 of income earned abroad is tax-free, so if you work in a country with no domestic taxes (common in the Middle East where oil revenues buoy the government’s coffers), then you can effectively earn tax-free. If you’re working for a foreign employer, then you don’t even need to pay Social Security and Medicare taxes at 7.65%. These savings can have a material impact on your wealth.
If we assume you’re paying a 20% effective tax rate in the US and 7.65% Social Security and Medicare tax on your U.S. wages, the tax savings of excluding those wages from taxation add up to $138,250 in five years. If you were to invest the tax savings at a 7% rate of return, those funds would grow to $167,283, of which $29,033 is return on investment. Confused? Look – graphs!
What does this tell us? There is a lot of power behind the FEIE. Anytime we can exclude income from taxation, we open the doors to some interesting tax-saving strategies. For example, if you are able to exclude all of your income from taxation due to the FEIE, you have the ability to convert traditional IRA balances to a Roth account tax-free, even though you’re still working. Let’s start with why and then move to how.
Money contributed to a 401k or a traditional IRA has been deducted from your taxable wages in the past, essentially making the income tax deferred to you (good). Let’s all thank Congress for providing this wonderful tax incentive to save for retirement. The money contributed to these accounts grows tax-free until the distribution, allowing your nest egg to balloon in size while compound interest does its magic. The downside of making these 401k/IRA contributions is that when the money comes out of that account (and it will come out (1)), it will be taxable as ordinary income (bad). Additionally, if you take the money out of this account before you turn 59½, then you have to pay a 10% penalty and the income tax. The incentives behind those rules is to encourage taxpayers to contribute to their retirement accounts, allow them to grow, and not touch them until near the end of life. Congress would never get their necessary tax revenues unless those distributions happened at some point, so they added the required minimum distributions to collect on those monies later.
Thousands of financial planners make their living managing tax issues regarding these required distributions. However, they don’t have to worry as much about the traditional IRA’s cousin, the Roth IRA, which has tax free distributions of principal that can be taken whenever the taxpayer chooses and can even be passed down to future generations without fear of required distributions. The reason it’s tax-free is that there was no tax deduction when the money was contributed, so the government already got their cut. The greatest value in the Roth IRA is the fact that investments in the account grow tax free and are distributed free from tax, so the money you take out is 100% yours.
Great, so traditional IRAs get a tax deduction on the front end but are taxed later, and Roth IRAs don’t benefit from a tax deduction on contribution, but are entitled to tax-free distributions. Is it possible to make a contribution to a traditional IRA, get the tax deduction, and then convert the amounts to a Roth IRA without paying tax?
The mechanics of an IRA distribution are best reflected by examining page 1 of a form 1040, every taxpayer’s annual financial reconciliation with the IRS.
This is what your 1040 would look like if you converted $10,000 of your traditional IRAs to a Roth IRA while earning $100,000. The Roth conversion creates a taxable distribution of $10,000 and your wages add $100,000 to your income. Total income is $110,000 and your tax bill would likely be $20,946 (assuming single and standard deduction). However, if you are working abroad and have access to the FEIE, you would get the following result:
In this image, you can see that the taxpayer has a the same taxable conversion on line 15b, but the mechanics of the FEIE create a negative -100,000 adjustment on line 21, reducing your income to only 10,000. The magic of this strategy is on page 2 of the 1040 where tax is calculated. With only $10,000 of taxable income, your standard deduction and personal exemption wipe out the tax on the IRA conversion.
So, here we have the ultimate retirement hack in tax-deductible contributions to your 401k/IRA and tax-free distributions of that same money after the Roth conversion.
You may be asking how much this trick is worth. After all, we’re only avoiding tax on $10,350 ($6,300 standard deduction + $4,050 personal exemption) of income. The benefits are visible in two arenas, tax savings and asset control.
How much tax are we saving by converting to a Roth? A comprehensive review of the client’s expected resources in retirement would be necessary to get an accurate amount, but we’ll use 20% for the sake of analysis. If we were able to convert $10,350 (before adjusting for inflation), that’s $2,070 of taxes saved each year you make a conversion.
However, if the taxpayer is married, the ceiling on conversion limits swiftly increases. The spouse would also receive a standard deduction of $6,300 and a personal exemption of $4,050, doubling the tax savings available to $4,080 each year ($6,300 x 2 plus $4,050 x 2 = $20,700 tax-free conversion x 20% expected tax rate). For each child they have they will be entitled to an additional $4,050 of excludable conversion income, netting $810 in tax savings. Lastly, if they itemize their deductions, each additional dollar of deduction they find by deducting mortgage interest and real estate taxes abroad will be available to them to increase their Roth conversion amount, tax-free.
Finally, we have largely ignored state taxes throughout this article, but I will mention them briefly here. While some states will allow either a partial or full exclusion of traditional IRA distributions from taxable income, there are many states that tax your full distribution. Expats who plan on returning to high-income tax states, such as California or New York, can reap significant tax savings of a Roth IRA conversion, because that income will be sheltered from the state’s 9%-plus tax rate.
Roth IRAs are not subject to required minimum distributions (RMDs). How valuable is this? It depends on each individual, the markets, and the taxpayer’s other assets. The essential issue regarding control is that a traditional IRA must make taxable distributions every year, whether or not the taxpayer needs the money. The money in the IRA is essentially “unwrapped” from its favorable tax deferred status. Further, the income will be subject to ordinary income tax rates upon distribution. In years where there is other significant taxable income, the RMD could push the taxpayer into an even higher tax bracket than they were in while working.
A less tax-oriented issue with control is a taxpayer’s estate planning consideration. If the taxpayer bequests a traditional IRA to his children or grandchildren, the required minimum distributions must still be made. In some scenarios the RMDs will be made based on the remaining life of the taxpayer, and in some scenarios will be based on the remaining life of the beneficiary. A Roth IRA can dodge the RMDs during the contributor’s lifetime, and the inherited Roth IRA will allow for tax-free distributions to your family.
So who does this tax strategy benefit the most? If you meet the following conditions, this strategy is suitable for you:
- Working overseas
- Earning less than $102,100 in 2017 (after converting to USD)
- Have traditional IRA or a 401K from a prior employer
- Perceive the value of the strategy and is willing to handle the paperwork involved
The addition of a nonworking spouse, children, and itemized deductions that exceed the standard deduction enhance the suitability of the idea.
While this is indeed a fairly niche strategy for tax avoidance, we must remain aware of the number of people claiming the FEIE. The State Department estimates that we have over 9 million citizens living outside of the United States, and the Internal Revenue Service statistics unit disclosed the filing of 449,277 returns containing a Form 2555 (to claim the FEIE) in 2011.