An Individual Retirement Account (IRA) is a popular and smart way that many Americans save for retirement. One can contribute up to US$ 5,500 per year (US$ 6,500 if age 50 or older). There are four things to keep in mind when contributing to an IRA:
1. IRAs have tax advantages;
2. To contribute, one must adhere to certain rules; and
3. For US expats that excludes foreign earned income, as there is additional complexity
4. There are multiple choices when a person inherits an IRA
IRAs have tax advantages
There are two basic types of IRAs: traditional and Roth. With a traditional IRA, one receives a tax deduction in the year of the contribution. As a result, it is possible to lower the amount of taxes owed to the US government by contributing to a traditional IRA. The second tax advantage is that the assets in the IRA are allowed to grow year after year without being taxed (referred to as tax deferral). However, taxes are owed at the back end when one takes distributions, or cashes out of the IRA.
With a Roth IRA, the tax advantage works in the opposite direction. There is no upfront tax deduction in the year of the contribution. However, the assets in the IRA grow year after year without being taxed, and distributions are also tax-free.
The general theory is that a traditional IRA is better than a Roth if your tax rate at retirement is lower than during one’s working years. On the flip side, a Roth is preferable to a traditional IRA if your tax rate at retirement is higher than during one’s working years. The issue with this theory is that it’s often difficult to estimate one’s future tax rates. Therefore, we advise clients to take advantage of both vehicles. That way, one can manage distributions (traditional vs. Roth) in a tax-efficient manner.
To contribute to an IRA, one must adhere to certain rules
Rule # 1: One must have taxable compensation or business income in order to contribute to a traditional or Roth IRA
Rule # 2: With a traditional IRA, one cannot contribute after reaching 70 ½ years in age
Rule # 3: With a Roth IRA, there are income limitations. With the exception of married couples filing separate status, the income limitations are reasonably high, so most people do qualify. Modified adjusted income (MAGI) thresholds for 2016 are stated below:
For US expats that exclude foreign earned income, there is some complexity
Many US expats utilize the foreign earned income exclusion (FEIE) to avoid paying taxes. For 2016, one can exclude up to US$ 101,300 in foreign earned income. If 100% of compensation were to be excluded on the tax return, then that person is ineligible to contribute to an IRA (referencing Rule #1 above).
There are several workarounds or solutions to the “zero taxable compensation” problem, including:
- If one earns slightly more than the FEIE amount, then potentially not exercise the foreign housing exclusion;
- If exercising the FEIE via the physical presence test, then utilize a 365-period that allows for some taxable compensation;
- If one is married filing jointly, potentially exercise the FEIE for one spouse and not for the other
There are multiple choices when a person inherits an IRA
The rules regarding inherited IRA are complex, and we cover only the basics (the two most common options).
- Spouses can treat the inherited IRA as his or her own; or
- Lump sum distribution – one can take the money all at once, but will owe income taxes on a traditional IRA (but not on a Roth)
The rules for a foreign spouse and other foreign beneficiaries are very similar to when the beneficiary is a US person.
Many US expats should consider contributing to an IRA. Saving for retirement as an expat is arguably more important than when one lives in the United States. An IRA has clear tax advantages. Although the qualifications may be more complicated for expats, they are surmountable with adequate planning.
For more information on retirement savings and other tax-related issues, visit us at: holaexpat.com.
This article was written by John Ohe – IRS Enrolled Agent and CFA. John is a partner at Hola Expat, a firm that specializes in tax services for U.S. expats.
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Disclaimer: The answers provided in this article are for general information, and should not be construed as personal tax advice. Tax laws and regulations change frequently, and their application can vary widely based on the specific facts and circumstances involved.