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4 Questions for U.S. Expats Investing in IRAs and Roth IRAs | Creative Planning International | Creative Planning International fka Thun Financial | YouTubeToText
YouTube Transcript: 4 Questions for U.S. Expats Investing in IRAs and Roth IRAs | Creative Planning International
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Core Theme
U.S. expats can contribute to IRAs and Roth IRAs, but eligibility and advisability depend heavily on their country of residence's tax laws and any applicable tax treaties with the U.S.
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- Hello, my name is David Kuenzi,
and I am the Director of International Wealth Management
at Creative Planning International.
And today I'm going to walk through four questions
for U.S. Expats Investing in IRAs and Roth IRAs.
The first question is, do you qualify
as an American expat to make an IRA contribution?
And generally the answer to that is yes.
Many Americans abroad believe they're not eligible
to make IRA contributions, but that is not correct.
An American is eligible to contribute
to an IRA from earned income,
even if that earned income is foreign earned income.
The biggest difference, however, as an American abroad,
is you have to consider the calculation
that determines whether or not you're qualified
to make that contribution or not.
And it is a little bit different
than it is in the United States,
primarily because we have to understand
that Americans abroad are very commonly employing
on their U.S. tax returns, something known
as the Foreign Earned Income Exclusion,
and/or the Foreign Housing Exclusion.
This allows them to exclude substantial portions
of their earned income from U.S. taxation
if that earned income was made outside of the United States.
To make an IRA contribution you need to have income
that exceeds those exclusion amounts.
You must have non-excluded, earned income
from which to make an IRA contribution.
And if your income is below those exclusions amounts,
you'll have zero non-excluded earning income,
and you cannot make an IRA contribution.
But for higher income Americans working abroad,
whose income exceeds those exclusions,
they're perfectly eligible under the U.S. rules
to go ahead and make an IRA contribution,
even from foreign sourced earned income.
Whether or not you want to make an IRA contribution,
however, under these circumstances,
is different than being eligible
to make the contribution itself.
Whether or not it makes sense
from a tax and finance point of view,
is primarily driven by considerations
about the local country of tax implications
of making that IRA contribution.
So let's walk through exactly what I'm talking about.
Aside from understanding the U.S. rules,
we also have to understand
how that IRA contribution will be treated
in the country-of-residence for the American expat.
For most Americans who are living in high tax countries,
what they will find is that,
after having paid their local country-of-residence taxes
and taking the foreign earned income exclusion,
and a credit for those taxes paid, they will have completely
eliminated their U.S. tax liability.
If they have no U.S. tax liability, then whether
or not they want to make an IRA contribution will depend
upon whether or not they're going to get a tax benefit
in the country in which they reside.
And if the country in which they reside
will not give them a tax benefit, as we'll see,
it will not make sense to make that IRA contribution.
Let's look at the example of Germany
that fits this scenario quite well.
Germany is a high tax country.
Americans living in Germany will find, generally,
that their taxes paid and their foreign earned income
exclusions will completely eliminate
their U.S. tax liability for the income
that they've earned in Germany.
Under these circumstances,
it will only make sense to make that IRA contribution
if Germany will give you a tax benefit for doing so.
But Germany, generally, will not permit a tax deduction
for contributions made to a U.S. IRA account.
Therefore there will be no tax benefit in Germany.
In this scenario, we're getting a tax benefit,
neither in the U.S. nor in Germany
for making this IRA contribution,
and therefore, generally, it does not make sense
to make the IRA contribution.
But we must take the analysis one step further
and look at what happens if we still go ahead
and make the IRA contribution.
In this case, we are going to fall into the trap
of ultimately double taxing ourselves
because we will take an IRA contribution
that generates no tax benefit in either the U.S. or Germany.
We will put it into the IRA.
We will essentially be recycling
an after-tax income item back into the IRA.
And when we go in retirement and withdraw that contribution,
it will be taxed again a second time,
and we will have effectively double taxed ourself.
This is unfortunately an all two common scenario and outcome
that we see among American expats who are contributing
when in fact it does not make sense.
So this raises the third question
that I want to address today.
How does your country-of-residence tax
U.S. IRA contributions?
Now this question needs to be answered
on a country by country basis.
We've now talked through the scenario of Germany,
where generally it does not make sense for an American
to make an IRA contribution,
but there are other countries where it does.
Let's walk through the example of Switzerland.
Switzerland, like Germany, is also a high tax jurisdiction,
but there the Double Tax Treaty that Switzerland has
with the U.S. allows for the deductibility
from Swiss taxable income of that IRA contribution.
Therefore, in this scenario, you are able
to get a benefit on your Swiss tax,
reduce your Swiss tax liability with the IRA contribution,
and therefore it now generally makes sense
to make that IRA contribution.
Furthermore, in Switzerland, assets held within an IRA
are exempt from the Swiss wealth tax,
giving further reason to accumulate assets
in an IRA account if you are an American in Switzerland.
Okay, let's now look at the example of Hong Kong.
Hong Kong is another case where, generally,
for higher income Americans it makes sense
to make an IRA contribution, but for different reasons.
In this scenario, Hong Kong is a low tax jurisdiction.
Americans in Hong Kong generally will not be able
to completely eliminate their U.S. tax liability
because the credits available from Hong Kong taxes paid,
will not be enough to offset the earned income
of higher earning Americans.
However, they can still make that IRA contribution
if they have income that exceeds the exclusion amount,
as we talked about earlier, and if they do,
they will be reducing the size of their U.S. tax liability
which they do have in this case
because they are in a low tax jurisdiction.
Furthermore, making that IRA contribution will have
no adverse or tax consequences in Hong Kong.
And therefore generally making an IRA contribution works
for higher income Americans.
It will reduce the current U.S. tax liability
and generally has the same effect as if you were back
in the United States.
So you can see through these examples that the decision
to make the IRA contribution ultimately comes down
to understanding whether or not you're eligible
in the U.S. to make the contribution,
and then understanding how that contribution will be treated
in the country in which you reside.
It's very specific to the country, the treaties that prevail
with respect to each individual country.
Now, let's address the fourth question
that we wanna look at here, which is,
does it make sense to do a Roth conversion
for Americans abroad?
Okay, the first question that we have to analyze
when we consider converting IRA or 401k assets
to a Roth IRA, is how will the distributions
from that Roth IRA ultimately be treated
in the country in which you reside when you expect
to withdraw that money from the Roth IRAs.
And if you expect to be living abroad at that time,
you have to ask, how will the country-of-residence,
at that point, treat those distributions.
Many countries will not respect the principle
that a Roth IRA distribution is tax free.
It is not explicitly recognized in the treaty.
In other countries, it is explicitly recognized
in the Double Tax Treaty that the U.S. may have
with those countries.
In other countries, there may be no tax treaty,
but certain countries may not tax distributions
from U.S. retirement accounts.
So again, we are very much in a scenario
where this decision is dependent
upon local country-of-residence tax treatment
considerations of that conversion.
But if the Roth will be acknowledged
and treated as tax free, and that could be
because there's a treaty provision,
as in the case of France or the UK or Canada,
that allows IRAs to be treated as tax free.
Or if you're in a country, say,
perhaps Costa Rica or Hong Kong,
where U.S. IRA distributions would not be taxed
in any case, whether they're traditional or Roth,
then the Roth distribution,
or I should say the Roth conversion,
is an option you wanna consider.
And now we default back to the decision framed purely
in the same terms it would be,
as if you were back in the United States.
And there, the decision depends
upon comparing your current tax rates
to your tax rates in retirement.
And generally the rule is if you expect your tax rates
in retirement to be as high or higher than they are now,
and again, make sure you're looking
at both the U.S. tax rate
and your local country-of-residents tax rate
on these distributions,
then you want to go ahead and make the Roth conversion.
So this is why we very frequently recommend
that people in their years before 72,
when they begin getting mandatory distributions
from their IRAs and their social security,
and they've already, and in those years in their sixties
typically when they stopped working
but are not getting investment, or they're not
getting retirement income, their tax rate goes way down.
Their tax rate in those years is gonna be lower
than their tax rates in their seventies,
when they start getting all of this retirement income
that is a perfect time to do a Roth conversion.
And if it works in the country where you reside,
it makes sense in an expat scenario.
So these are the kinds of tax strategies,
financial planning strategies that we are looking at
and working on with our clients all around the world
every day here at Creative Planning International.
This underscores the complexity
of making these decisions
with respect to our retirement and financial plans,
given the complexity of cross-border taxation
for Americans abroad.
Thank you.
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