Roth Conversion Strategies for US Expats

Roth contributions and conversions can be beneficial for American expatriates when they anticipate paying similar or higher taxes during retirement. The exemption from state taxes for most expats living abroad makes Roth conversion an even more valuable option. In most cases, it makes sense for expats take advantage of these investment opportunities while they’re still living outside of the U.S., but this will depend on certain factors like your country of domicile’s tax treatment of Roth IRAs, and where you plan to retire. The Roth IRA also allows expats who plan to retire in the U.S. to receive tax free income on both federal and state level.

The significance of state taxes in determining whether an expat should make a Roth conversion will be discussed in detail in this article.

1.Why State Taxes Are Essential for U.S. Expats to Consider

Future tax rates can be difficult to forecast due to a variety of unforeseen reasons. However, for the majority of Americans, the state tax rate has little bearing on the results of calculations for Roth contributions and conversions. Most of the time, state tax rates change in a similar pattern to federal tax rates between working and retirement years. As a result, you may probably anticipate a comparable change in state tax rates if you predict that your federal tax rate will vary during retirement.

For Americans residing abroad, this presumption is inaccurate. Most U.S. expats abroad are exempt from paying state taxes. Therefore, even though federal tax rates decrease with income during retirement, when we consider state taxes throughout the lifetime of Americans who are currently living abroad, we frequently find that future tax rates (both federal and state) will be higher than current tax rates (federal only).

Roth conversion is often the optimal choice when future tax rates are similar to or higher than current tax rates. Therefore, a comprehensive review of the Roth conversion calculation that considers state tax rates will frequently make Roth contributions and conversions more favorable.

2. Other Factors U.S. Expats Should Consider with Roth Conversions

Before performing a Roth conversion, expats should take into account the following additional factors:

 Where will you retire?

The biggest challenge is taking into account the tax burden of the state where you plan to retire.

• For those who intend to retire in a state with no income tax, such as Florida, the state tax analysis will have no bearing on the Roth conversion calculation.
• The role of state taxes may or may not influence the decision to use a Roth for those planning to retire in states with relatively low-income tax rates, such as Illinois.
• For individuals expecting to retire in high-tax states like California, New York or Oregon, including state taxes in the Roth calculation will likely result in a recommendation to use a Roth (contributions/rollover), even if the conclusion was not already clear based on analysis of federal tax rates alone.

But if you are planning to retire abroad, then state taxes don’t necessarily need to be a concern.

3. Country of Residence Tax Implications

It’s crucial for U.S. expatriates to assess any potential local tax repercussions of a Roth conversion. Distributions from IRAs may be taxed in certain jurisdictions, which renders the conversion less desirable.

4. Changing Tax Policies

It is crucial to note that tax policies are subject to change. Even though recent tax increases have occurred, overall income tax rates still remain relatively low in comparison to historical levels. It is expected that future tax rates will increase. This alone is a significant factor that favors Roth conversion at present, when rates are still relatively low. This is an additional compelling reason to consider making contributions and converting to a Roth now.

5. Tax Diversification Among Retirement Accounts

It may not be possible for younger taxpayers or those only moderately well-off to determine if converting is financially beneficial.

Due to the numerous variables associated with future financial circumstances during retirement, it can be challenging to predict applicable tax rates with certainty. As such, implementing a strategy of tax diversification may be advisable for taxpayers.

By distributing their retirement accounts between Roth and traditional options, taxpayers can mitigate the potential risk of experiencing a significant change in their marginal tax bracket during retirement, as compared to their expectations when initially choosing between traditional or Roth IRA. This strategy of tax diversification is particularly beneficial for American expats, as it addresses the added complexity of conversion calculation in light of their unique tax and planning considerations.

6. Roth Conversions Could Result in a Lower Retirement Tax Bill for Returning U.S. Expats

Choosing the appropriate strategy for a Roth conversion requires careful consideration of several factors. For U.S. expats in particular, a comprehensive review of state taxes is essential as it frequently determines whether a Roth option is suitable, although it is not the only issue to be taken into account.

Using Roth accounts is an alternative for U.S. citizens living abroad to permanently shield their income from state taxes. Particularly for high-income households, this one advantage can result in a sizeable amount of additional post-tax investment income, which might total hundreds of thousands of dollars.

To ensure you make the right decision for your unique financial situation, including the factors specific to U.S. expats, it’s crucial to conduct a thorough examination. And as always, seeking guidance from a qualified cross-border financial professional is highly recommended before making a final decision.