Finance-savvy expats are always looking for the best way to opimize their finanial health and plan for a carefree retirement. Some of the questions we are asked the most are:
- “How can I continue contributing to my U.S. based retirement accounts while living abroad?
- “What is the most effective contribution, and what am I allowed to contribute?”
Expats face additional challenges when it comes to contributing to IRAs, especially considering factors like the foreign earned income exclusion and foreign tax credits.
Let’s start with the foreign earned income exclusion. Many expats qualify for this exclusion, which allows them to exclude a certain amount of their foreign earned income from U.S. taxation. For tax year 2024, the maximum exclusion amount is $126,500 per qualifying individual. This exclusion can effectively reduce or eliminate a taxpayer’s U.S. taxable income, which in turn affects their eligibility to contribute to a Roth IRA or deduct contributions to a Traditional IRA. If the exclusion wipes out their earned income for U.S. tax purposes, they may not have any eligible income to contribute to an IRA.
Furthermore, expats who receive foreign tax credits may find that contributing to a Traditional IRA doesn’t provide the same tax benefits as it would for U.S. residents. Foreign tax credits allow taxpayers to offset their U.S. tax liability with taxes paid to foreign countries. If an expat’s foreign tax liability exceeds their U.S. tax liability, they may not owe any U.S. federal income tax after applying the credits. In this scenario, contributing to a Traditional IRA, which provides a tax deduction for contributions, may not make financial sense since they’re not paying U.S. federal income tax on that income anyway.
Let’s delve into your options regarding contributing to a Roth IRA or Traditional IRA while living abroad.
First off, both types of IRAs can be great tools for retirement savings, but they come with their own set of rules and limitations. For expats, one of the primary considerations is whether they have earned income from U.S. sources, as this is a requirement for IRA contributions.
Roth IRA
A Roth IRA (Individual Retirement Account) is a type of retirement savings account that offers unique tax advantages. Unlike a Traditional IRA, contributions to a Roth IRA are made with after-tax dollars, meaning you don’t get an immediate tax deduction for your contributions. However, the key advantage of a Roth IRA lies in its tax treatment of withdrawals.
With a Roth IRA you get:
- Long term tax-free growth: One of the most compelling reasons to use a Roth IRA instead of a Traditional IRA is that your money will grow tax-free for decades, and when you withdraw it in retirement, that withdrawal won’t come with a hefty tax bill.
- Tax-free withdrawals in retirement: Qualified withdrawals from your Roth IRA in retirement are tax-free. You paid income tax on your contributions before investing, so you can withdraw your contributions and gains in retirement without paying tax. This will help with budgeting in retirement, because you won’t have to account for tax on withdrawals. It’s also especially helpful if you expect to be in a higher tax bracket in retirement than you were when you were working.
- Ability to withdrawal principal without penalty: Even though a Roth IRA is a retirement account, it can also be used as an emergency fund, because you can withdraw your Roth IRA contributions (principal) without a penalty after you’ve had the account open for 5 years. Of course it’s better to keep retirement funds locked away in the account to accrue long term gains, but it is nice to know that you have access to your principal if absolutely needed.
- No required minimum distributions (RMDs): Roth IRAs do not have required minimum distributions (RMDs) like Traditional IRAs and 401(k)s. This means you can choose to keep your money invested longer instead of being forced to withdraw it. The ability to keep your money invested longer potentially means higher gains, more money to sustain you in retirement, and more to leave to your heirs if you choose to do so.
- Tax diversification for retirement planning: Depending on your situation, it can be a good idea to diversify the types of retirement accounts you have, and having a Roth IRA is one way to do that. For example, Traditional IRAs with tax-deferred contributions can allow you to maximize the amount of dollars you have available to contribute to a retirement account while working by avoiding paying income tax before investing, while Roth IRAs allow you to maximize the amount of dollars you have available in retirement by avoiding paying income tax on the withdrawals in retirement. Using one or both types of accounts can help you reach your goals.
Your eligibility to contribute to a Roth IRA begins to phase out if your modified adjusted gross income (MAGI) exceeds certain thresholds. For 2024, for instance, the phaseout for single filers starts at $129,000 and phases out completely at $144,000. For married filing jointly, the phaseout starts at $204,000 and ends at $214,000. These limits are adjusted annually for inflation.
If you are an expat using the foreign earned income exclusion, you may be excluding all your earned income and may not be able to contribute to a Roth IRA. Additionally, some countries, like The Netherlands, impose annual taxes on accounts like a Roth IRA.
Traditional IRA
A Traditional IRA (Individual Retirement Account) is a retirement savings account that allows individuals to make contributions with pre-tax dollars, providing an immediate tax deduction in the year of contribution. The contributions and investment earnings grow tax-deferred until withdrawal, at which point they are subject to ordinary income tax.
With a Traditional IRA you get:
- Immediate tax deduction: One of the most compelling reasons to use a Traditional IRA is that contributions are tax-deferred, meaning you avoid paying income tax on those contributions in the year you make them, but you’ll need to pay income tax on the contributions and gains in the year you withdraw them. Contributing to a tax-deferred account allows you to maximize the amount of dollars you have available to invest at the time of contribution. This is a good way to front load the account, especially if you started later in life.
- Tax-deferred growth: In a Traditional IRA, both contributions and gains grow tax-deferred until you withdraw the funds in retirement. This tax-deferred growth means your investments will compound over time without being eroded by annual taxes on dividends, interest, or capital gains. Tax-deferred growth can accelerate the growth of your retirement savings, especially if you have a long timeline.
- Benefit for lower tax bracket in retirement: Traditional IRAs are beneficial if you think you will be in a lower tax bracket in retirement than you were while working. Withdrawals from Traditional IRAs are taxed as ordinary income, so if your income drops in retirement, you may be in a lower tax bracket and therefore pay less tax on all income (including IRA withdrawals) than you would have paid on your contributions during your higher-earning years.
- Required Minimum Distributions (RMDs): Traditional IRAs are subject to Required Minimum Distributions (RMDs) starting at age 72 or 73 depending on your birth year. RMDs ensure that the government finally gets to collect the taxes on the contributions and gains in your account, which have been deferred for decades. RMDs provide income in retirement, but they also increase your taxable income and thus your tax liability. RMDs can also affect your tax bracket and Medicare premiums, so that’s something to keep in mind while you’re planning for retirement.
- Tax diversification: As mentioned above, having a combination of tax-deferred and tax-free retirement accounts can be a strategy towards diversification to help you reach your goals.
With a Traditional IRA, there are no income limitations for making contributions, but there are income limitations for deductibility. If you’re covered by an employer-sponsored retirement plan like a 401(k), the deductibility of your Traditional IRA contribution might be reduced or eliminated based on your income.
How do I decide which account is best?
Three questions to consider when deciding between a Roth IRA and a Traditional IRA contribution:
- What’s your current tax situation, and how do you anticipate it changing in retirement?
- Are you looking for tax-free withdrawals in retirement (Roth IRA) or prefer tax-deferred growth with potentially tax-deductible contributions now (Traditional IRA)?
- How confident are you in your ability to accurately predict future tax rates?
These questions can help us assess your short-term and long-term financial goals, as well as your tax strategy.
Backdoor Roth IRA Conversion
Now, let’s talk about the “backdoor Roth” contribution. Essentially, it involves making non-deductible Traditional IRA contributions and then converting them to a Roth IRA. This strategy can be advantageous for high-income earners who are ineligible to directly contribute to a Roth IRA due to income limitations, and for expats who may have excluded their income and been ineligible to contribute to a Roth IRA and who will pay little or no tax on the conversion. There are strict limitations on the conversion and should be reviewed before moving any funds.
How much can I contribute?
For tax year 2023, the maximum annual contribution limits for both Roth and Traditional IRAs are as follows:
- $6,500 for individuals under age 50
- $7,500 for individuals age 50 and older (including a $1,000 catch-up contribution)
For tax year 2024, the maximum annual contribution limits for both Roth and Traditional IRAs are as follows:
- $7,000 for individuals under age 50
- $8,000 for individuals age 50 and older (including a $1,000 catch-up contribution)
Key deadline dates:
- For 2023:
The deadline for making IRA contributions for the 2023 tax year is usually April 15, 2024.
- For 2024:
The deadline for making IRA contributions for the 2024 tax year is again likely to be April 15, 2025.
BNC Tax & Accounting B.V. advises U.S. taxpayers on long-term tax planning strategy. Book a consult today to discuss the advantages of contributing to your retirement accounts while living abroad.