February 28, 2022

Funding traditional retirement planning vehicles (401k, IRA, ROTH) for Americans living in the US has always been about the maximization of tax benefits to optimize retirement investment returns and distributions over time. The complexities of these retirement vehicles are magnified once you leave American soil, which makes it a lot more challenging for US expats to optimize their retirement savings while living abroad.  Developing a sound financial strategy is essential for US expats who wish to save for retirement and optimize their tax savings while living and working in other countries.

What’s the best retirement plan vehicle for US expats living abroad?

Selecting the ideal retirement plan strategy for US expats requires a comprehensive assessment of your retirement goals, tax laws in your current country of residence, tax laws in the country you wish to retire, retirement plan vehicles that are available to you and your income status among other things.  You also need to understand the IRS definition of whether your income is considered earned or unearned:

Earned income: A salary, wages, business income and other sort of revenue obtained by performance of a job, employment, or services.

Unearned income: Money that you acquire without having to “work” for it. This would include passive income (interest, dividends, and capital gains), as well as payouts from retirement accounts, social security payments, unemployment distributions, gambling, rental income and other sources.

A requirement to contribute into most qualified US retirement plans is to have “earned income” that is equivalent or greater than the amount being contributed.  Therefore, if your “earned income” for the year is only $3,000, you may not contribute more than $3,000 in qualified retirement plans such as an Individual Retirement Account (IRA) or Roth IRA. 

Special Considerations for US Expats

US taxpayers living abroad may elect for either tax credits or the Foreign Earned Income Exclusion (FEIE) and Foreign Housing Exclusion on their taxes.  The FEIE election allows an expat to exclude up to $108,700 (adjusted for inflation) in foreign earned income as of 2021.  Expats who live in countries with a lower tax regime than the US, usually go for the FEIE election.

Contributions to any qualified retirement plan that provide a tax advantage (now or in the future) must be made with “earned income” that has not been exempted from your US expat taxes. This essentially implies that you cannot utilize money that you have excluded on your US tax return using the FEIE. This restriction applies to contributions into qualified retirement accounts such as an IRA or Roth IRA.

As a simple example (without Foreign Housing Exclusion), let’s say a US expat whom we will call John Doe is currently residing in the Philippines.  In 2021, John earned an income of $80,000 working in the Philippines and elected for the FEIE(may exclude up to $108,700 of foreign income) on his 2021 US tax return, thereby excluding his entire $80,000 income from US taxes.  This means that although John had employment income of $80,000 in 2021, he may not contribute to an IRA or Roth IRA due to the fact that his income would now be considered “unearned income” by the IRS for the purpose of qualified contribution to a retirement account.

On the flipside, if John Doe earned $200,000 in 2021, he may have excluded $108,700 of his income by electing FEIE and used tax credits on the balance.  This means that John may now consider $91,300 ($200,000-$108,700) as earned income, thereby making him eligible to contribute to a qualified retirement account.

In cases where a US expat lives in a country where the tax rates are similar or greater than that in the United States, they usually opt for the Foreign Tax Credit (FTC) instead of the FEIE. In such cases, contribution to a qualified retirement account may be allowable.

However, skipping the FEIE has some fiscal consequences. If you took it in the preceding year, you won’t be allowed to take it again for five years, and once that time has passed, you’ll need to apply and get authorization to take it again. This shouldn’t be a problem for a US expat who resides in a country with a high tax rate and has little or no income from the United States.

If you live in a country with low or no-income taxes, skipping the FEIE may not be the best option as you may end up paying more taxes than your contributions to a qualified retirement plan would cover. If your income exceeds the FEIE, you may be allowed to contribute the excess earned income to a retirement plan, subject to plan contribution restrictions.

It’s also worth noting that most countries outside the US don’t recognize the tax benefits of a US qualified retirement account, so contributions to a US qualified retirement plan may not be recognized as an income deduction in your home country or even tax deferred or tax-free growth, and you may be compelled to pay taxes on that income there. Before making contributions as a US expat, you should do your homework, review tax treaties and learn about the tax rules of your host country.

Likewise, retirement plans in other countries may not be recognize by the US, thereby presenting a whole different set of issues as US expats participate in foreign retirement plan schemes.

Types of Expat Retirement Plans: Can U.S. Expats Contribute to a 401(k)?

So, which kind of retirement account should you fund? Depending on your employment status and current and future (anticipated) tax rates, you’ll discover you have various alternatives from which to choose, each with its own set of pros and cons. Here are some alternatives for you:

• IRAs: Traditional and ROTH
• 401(k): Traditional and Solo 401(k)
• SEP (Simplified Employee Pension)
• SIMPLE IRA

If you are employed (with earned income), you may contribute to a traditional IRA or Roth IRA, as well as a 401(k) or SIMPLE IRA set up by your company if they offer it. But can expats contribute to 401(k)s? In most circumstances, if you work for a foreign company, you may not have access to an expat 401(k) or SIMPLE IRA since they are set up within US borders.

Self-employed individuals have broader options where you may also establish an IRA, Roth, solo 401(k), SEP, SIMPLE and other pension plans depending on your income, tax situation and retirement objectives.

If you have a 401(k) from your past employment in the US, you may also consider rolling it over to a “rollover IRA” for better control or convert it to a Roth IRA depending on your situation and retirement objectives.

Life insurance also offers non-traditional retirement savings strategies.  But this is a bit more involved and sophisticated strategy to be discussed for another day.

Traditional IRA vs ROTH IRA

The main distinctions between these two is the tax treatment on the “contributions” and “distributions” at retirement. Contributions to a traditional IRA may or may not be tax deductible and may be considered for “tax deferred” growth in the US. This means however, that distributions at retirement will be taxable at some point.

Meanwhile, “contributions” to a Roth IRA are made with after tax dollars (not tax deductible) but the growth is considered “tax free” in the US, which means that “distributions” at retirement are free of taxes in the US. Beware that most tax treaties are old and do not recognize the tax-free nature of the Roth IRA.  Proceed with caution.

In conclusion, retirement planning is complex enough for US residents let alone for expats living abroad.  The complexities are overwhelming once you leave US soil or grow a multi-national family abroad.  Most local financial advisors in the US are focused on their local clients to even bother about the intricacies of cross border retirement planning.  Because each plan has its unique set of international regulations and limitations, it’s always a good idea to speak to an expat tax professional about your personal tax situation and a cross-border financial planner to make the best investment decisions and avoid expensive mistakes.

Disclaimer

• The information provided is for educational purposes only and does not constitute personal financial, tax or investment advice and should not be relied on as such.  It does not take into consideration any investor’s particular investment objectives, strategies, time horizon, and tax or legal status.  Abacus Wealth International (AWI) does not provide tax or legal advice.  Please consult a tax or legal professional for corresponding tax and legal advice.
• All material and content have been obtained from sources believed to be reliable.  AWI does not guaranty the accuracy of the information provided and shall not be held liable for decisions based on the foregoing information.  
• All examples of graphs, financial products and historical returns contained in the foregoing material is for illustration and educational purposes only and shall not be deemed as financial advice or recommendation.  Past performance is not indicative of any future investment returns.