Alongside the laws of thermodynamics and universal gravitation, two other great truths are woven into the fabric of space-time:
- with great tax benefits come great complications and
- life as an expat involves constant coordination of different systems that don’t always work well together.
And so it goes when expats invest through individual retirement accounts (“IRAs”). Some of the rules here are fairly straightforward, but there are a few twists and turns that can lead to unhappy surprises on your tax return.
IRAs come in two basic flavors—the traditional IRA and the Roth IRA. With a traditional IRA, you can take a deduction for the amount you contribute, you don’t pay tax on investment gains, and distributions from the account are subject to tax. With a Roth IRA, you don’t get a deduction for contributions, you still don’t pay tax on investment gains, and distributions from the account are tax-free.
You can generally use the foreign earned income exclusion (the “FEIE”) to eliminate US income tax on about $100,000 of foreign earned income. Or, instead of using the FEIE, you can claim the foreign tax credit to reduce your US tax bill dollar-for-dollar by the amount of non-US income tax you paid on such income. If you initially choose the FEIE and then later want to switch to the foreign tax credit, you can’t switch back to the FEIE within 5 years without obtaining a ruling from the IRS.
Two Great Tastes that Taste Great Together
Here’s how the IRA rules and special expat tax rules come together: You can generally contribute up to $5,500 per year to either a traditional or Roth IRA (see IRS Publication 590-A for all the nitty-gritty rules on participation phaseouts and eligibility limitations etc. etc.). However, you cannot contribute more than your “taxable compensation” each year.
Taxable compensation is generally the amount you earn from working minus any amount you exclude under the FEIE. So, if you claim the FEIE, you can generally only contribute to an IRA if your foreign earned income is at least $5,500 higher than the amount you can exclude under the FEIE.
Beware the Roth Misconception
For a traditional IRA, the rule above makes intuitive sense because the deduction you would receive for the contribution would take your income negative. Some people erroneously extend this idea to conclude that they can still contribute to a Roth IRA even with income below the FEIE amount because they aren’t claiming a deduction for the contribution.
However, that’s not the case—you still need at least $5,500 of taxable compensation (i.e., foreign earned income over the FEIE amount) to even be able to make the contribution, even if the contribution is to a Roth IRA.
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Two Paths Forward
Now that you know all the rules, let’s see how they come together in the real world. There are generally two paths forward for expats whose foreign earned income is below the FEIE amount:
- claim the foreign tax credit and keep contributing to an IRA or
- don’t contribute to an IRA and instead make investments that essentially replicate the results of a traditional IRA.
Actually-there’s a third path that not many people know about. I’ll explain more below.
Path 1: Claim the Foreign Tax Credit and Keep Contributing to an IRA
The first path works great for expats in high-tax countries. If you move to the UK or Germany or Sweden etc. etc. and are subject to tax in your new country, you’re very likely going to pay taxes that are higher than your US taxes. The foreign tax credit would therefore completely eliminate your US income tax liability and allow you to keep investing in an IRA.
This path doesn’t work so well for those in lower-tax countries (or those who are not subject to tax in their new country)—the foreign tax credit doesn’t do much for them, and it is hardly worth forgoing the benefits of the FEIE just to keep contributing to an IRA.
Path 2: Claim the FEIE and Invest through a “DIY IRA”
For these folks, the second path works better—the “do-it-yourself IRA.” This path involves simply arranging your investments in such a manner as to replicate the benefits of a traditional IRA. Recall that with a traditional IRA you get a deduction on the contribution, the investment gains are tax-free, and distributions are taxable. When you claim the FEIE and use a DIY IRA, you essentially get a deduction on the contribution because none of your income under the FEIE cap is subject to U.S. tax—an exclusion is the same as a deduction (it’s actually better because it’s not subject to phaseout or limitations).
Next, you can eliminate tax on investment gains simply by making investments that don’t produce taxable income or gain during your hold period. So, you can buy tax-exempt bonds, individual growth stocks, interests in exchange-traded funds, raw land, or other types of investments that simply appreciate over time without throwing off income. Finally, when you are ready to sell your investments, you’ll pay tax just as you would upon receiving a traditional IRA distribution.
What if you Over-Contribute?
If you make a contribution to an IRA and then later find out that the contribution wasn’t allowed (e.g., because you claimed the FEIE and your foreign earned income was under the FEIE amount), then you should never visit the US again because they’ll haul you off the plane and take you straight to jail.
OK, not really. The actual consequences aren’t quite that bad—you just have to pay a penalty each year equal to 6% of the erroneous contribution. You can avoid that penalty simply by asking your IRA custodian to distribute the erroneously contributed amount (together with the earnings on such amount)—you’d just need to pay tax on the earnings. You would avoid the penalty entirely if that distribution is made before you file your return for the year you made the erroneous contribution.
If you discover that a contribution made in a year for which you’ve already filed a return was erroneous, you can avoid the penalty tax by amending your return for that year to claim the foreign tax credit instead of the FEIE. Of course there’s some math involved to determine if the amendment would provide a net benefit. Also, you generally wouldn’t be able to claim the FEIE again for 5 years after switching to the foreign tax credit.
The Offshore IRA
While living in the US, your IRA was probably invested in one of the mutual funds offered by your multi-billion-dollar IRA custodian. However, now that you’re living outside the US, different types of investments may have caught your eye (such as non-U.S. real estate), or you may simply want to diversify your investments to include more non-US exposure.
Many expats are surprised to learn that they can actually use the funds in their IRA to make these types of investments. To do this, you first need to create an offshore IRA structure by (i) changing IRA custodians to one that allows self-directed IRAs and then (ii) causing your self-directed IRA to invest through a non-US legagl entity (to allow you to obtain control over your investments and reduce custodial fees). Needless to say, these structures can be complex from a tax perspective, and expert tax planning and compliance are both crucial.
When expats and IRAs intersect, there are new rules to learn and disparate systems to coordinate, which is all par for the course both for special US tax programs and for life as an expat.
OK, remember that third path I mentioned above? Well, there’s a special trick you can use on your tax return so you can contribute to an IRA and still claim the FEIE even when you make less than the FEIE cap. And it’s perfectly legal and legitimate-no funny business at all. All of the details are explained in Tax-Savvy Expat: Essentials, the first of my three online courses. You really need to get the full explanation of the FEIE contained in the course so you can understand how this special trick works.