As a US expat, retirement planning and investment decisions can be more complicated than for Americans in the States. Navigating two countries’ tax landscapes and understanding how different retirement accounts can be beneficially utilized is a central pillar of planning a secure and fulfilling future.
Americans living abroad can contribute to and continue to hold US retirement accounts, including IRAs and Roth IRAs. In this article, we discuss the options American expats have to benefit from these retirement accounts and effectively manage their plans while living abroad.
US retirement accounts for expats at a glance
Various retirement accounts such as IRAs, 401(k)s, Roth IRAs, Individual 401(k)s, 403(b)s, deferred compensation plans, and defined benefit employer pension plans offer Americans a range of saving choices. Each comes with its own tax implications, compliance rules, contribution restrictions, mandatory withdrawal requirements, and other features. For Americans living abroad, additional complexities arise, including considerations for both US and country-of-residence taxes.
The good news is that Americans abroad generally enjoy similar rights and opportunities as those residing in the US in terms of US tax benefits from retirement accounts. Despite additional considerations, with proper planning and under specific circumstances, US expats might even leverage their foreign residency to their advantage.
What’s the difference between a traditional IRA and a Roth IRA?
A Traditional IRA and a Roth IRA are two distinct types of Individual Retirement Accounts, each with its own set of rules, tax implications, and benefits. Let’s look at the key differences between them using examples:
Tax Treatment
Traditional IRA:
- Contributions to a Traditional IRA are typically tax-deductible in the year they are made.
- Earnings within the account grow tax-deferred until withdrawal.
- Withdrawals during retirement are taxed as ordinary income.
Roth IRA:
- Contributions to a Roth IRA are made with after-tax dollars, meaning they are not tax-deductible when you contribute.
- Earnings grow tax-free, and qualified withdrawals during retirement are also tax-free
Example
Traditional IRA:
- In 2024 you may be able to contribute up to $7,000 ($8,000 if over age 50) to a Traditional IRA. If you are in the 24% federal tax bracket, you could potentially set aside an extra $1,680 in a tax-deferred Traditional IRA account as compared to taking $7,000 as income, paying tax on it and then investing the funds in a regular brokerage or savings account.
Roth IRA:
- If you contribute $7,000 to a Roth IRA, you don’t get an immediate tax break. However, when you withdraw the funds in retirement, qualified withdrawals, including earnings, are tax-free.
Age Restrictions
Traditional IRA:
- If you reach age 732 and have a Traditional IRA, you are required to take minimum distributions, which may impact your tax situation.
Roth IRA:
- There are no required minimum distributions during the account owner’s lifetime, allowing for more flexibility in managing withdrawals.
Withdrawal Rules
Traditional IRA:
- Early withdrawals before age 59½ may incur a 10% penalty, in addition to ordinary income tax.
Roth IRA:
- Contributions to a Roth IRA can be withdrawn at any time without penalties. Earnings, however, may be subject to penalties and/or tax, if withdrawn before age 59½ or if the Roth account has not been in existence for over 5 years.
Understanding these differences is key to making informed decisions about which type of IRA aligns best with your financial goals and circumstances. There are also other considerations and limitations that affect the ability to contribute to IRA accounts or to deduct Traditional IRA contributions, such as whether your spouse has an employer pension plan, or the amount of income you have, or whether you have US taxable income. Some of these are discussed later in this article but it is best to have a conversation with your tax advisor regarding these issues.
How Roth IRA accounts operate
Unlike contributions to traditional retirement accounts such as 401(k)s and IRAs, contributions to Roth accounts do not offer an immediate tax benefit, as they are not tax-deductible in the year of contribution. While traditional IRA accounts reduce taxable income for the year of contribution, the tax benefit they provide is essentially a deferral. In contrast, Roth accounts do not provide an immediate tax benefit but offer tax-free withdrawals in retirement.
Benefits of Roth IRAs for expats
Roth accounts offer a unique advantage in that earnings, including interest, dividends, and capital gains, remain untaxed upon withdrawal. Unlike traditional retirement accounts, where earnings are tax-deferred, Roth IRAs provide tax-free withdrawals, making qualified distributions entirely tax-exempt. The decision to opt for a Roth over a traditional IRA involves a trade off between giving up tax deferral on contributions and earnings in exchange for tax exemption on draws from the investment income later.
Expat considerations for IRAs
American citizens residing outside the US have the option to contribute to a US IRA, provided they have earned income that they haven’t excluded by claiming the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion (FHE). For example, an American citizen working abroad for a foreign corporation and earning $100,000 a year, who can exclude all income from US taxation under the FEIE, won’t have “non-excluded” income for an IRA contribution and therefore cannot contribute.
On the other hand, a higher-income expat with $200,000 in earned income, leveraging a combination of the FEIE and FHE, or if they claim the US Foreign Tax Credit to reduce their US tax liability, can contribute. However, if by claiming credits and exclusions they eliminate all their US tax liability, a traditional IRA contribution would provide no immediate tax benefit and would be taxed upon withdrawal in retirement. Once again, local taxation must be considered as well. If the US expat’s income is subject to local taxation, then the question arises as to whether Traditional IRA contributions would be exempt from local taxation even if they are exempt from US taxation. Tax treaties usually provide guidance on this as well.
In general, IRA contributions may be a good idea for higher earning expats who live in countries with lower income tax rates than the US where claiming US exemptions and credits won’t eliminate their entire US tax liability.
In this scenario, Roth contributions (and conversions) make financial sense if you are expecting to pay similar or higher US tax in retirement as now.
Another consideration for expats who expect to retire abroad is whether the tax benefits of Roth IRAs are recognized in the country where they plan to reside. This depends on the details of the particular tax treaty the US has signed with that country. Most tax treaties do not specifically mention Roth IRA accounts, they just refer to “pension” accounts. Traditional IRAs generally fall into the pension account category for tax treaties but not necessarily a Roth – in which case the Roth may be treated just like a regular taxable investment account for local tax purposes. Most tax treaties also provide that pension distributions are taxable in only the country of residency, therefore US taxation may not even apply to an expat’s IRA distributions, although there is something called the “Savings Clause” in most tax treaties that could negate this and sometimes there is a distinction between lump-sum vs. non-lump-sum distributions. Clearly the tax considerations of US retirement accounts are much more complex for non-US residents, therefore we recommend you always seek professional advice when retirement planning as an expat from an expat specialist financial advisor.
Final thoughts
There are also other considerations for US expats with retirement accounts. For example, there may be complexities surrounding transfers to beneficiaries if the account holder passes away while resident outside the USA or if a beneficiary is not a US person for tax purposes. Ultimately, the best decision for you and your family depends on a comprehensive analysis of your financial situation, taking into account the unique factors relating to American expats. We strongly advise seeking guidance from a qualified US expat investment advisor before making any decisions. Their expertise can provide valuable insights for your specific circumstances, ensuring that your financial choices align with your goals and the complexities of living abroad as an American expat.
If you have any questions about financial planning as an American living abroad, get in touch.
This article is for informational purposes only; it is not intended to offer advice or guidance on legal, tax, or investment matters. Such advice can be given only with full understanding of a person’s specific situation.