Even under the most conventional of circumstances, American taxpayers struggle to fully understand the myriad of tax advantaged retirement investment options they have.  IRAs, 401(k)s, Roths, Individual 401(k)s, 403(b)s, 527s, and defined benefit employer pension plans are some of the many possible investment choices from which American taxpayers might choose.

Each has slightly different tax implications and a separate set of complex compliance rules, contribution limits, mandatory withdrawal requirements and other features.   Being an American abroad, however, further complicates matters by injecting additional tax and planning complexities into the equation.  The good news is that Americans abroad generally have the same opportunities as do Americans at home to accrue tax benefits from tax advantaged retirement accounts.  In fact, under certain circumstances and with proper planning, expats may gain more than most from the proper employment of these accounts. 

The following article is the first of two articles written for Expatica that look at the proper use of retirement accounts for Americans living abroad.  In the first article, we discuss the difference between the “traditional IRA and the “Roth IRA” and how Americans abroad can take full advantage of these tax-advantaged retirement accounts.  The second article, ’The Roth IRA Conversion Decision for Americans Abroad’ is a guide to understanding when it makes sense to convert a traditional IRA into a Roth IRA, especially in light of the significant change in rules regarding “conversion” that begin in 2010.

Understanding the Difference between a “Traditional” IRA and a “Roth” IRA

Many investors will be familiar with the concept of the IRA (Individual Retirement Account), commonly referred to as a “traditional IRA.”  These accounts allow taxpayers to contribute up to USD 5000 of their earned income to an IRA account each year (USD 6,000 if over 50 years) and receive a corresponding tax deduction (similar tax-deferred employer sponsored retirement plans such as 401(k)s have higher contribution limits).    Therefore, a taxpayer in the 25 percent marginal tax bracket will get the immediate benefit of saving USD 1,250 on their current year tax bill (USD 5000 x .25) if he makes a maximum contribution to a traditional IRA.  Investments in an IRA account grow tax-deferred until retirement.  At age 59 years and six months distributions can begin.  Distributions are, in most cases 100 percent taxable at the owner’s marginal tax rate, however.  Furthermore, starting at age 70 years and six months, minimum annual distributions based on the account owners life expectancy become mandatory.

In addition to annual contributions, traditional IRA accounts may also be funded by the rollover of an employer plan (401(k), profit sharing plan, 403(b), etc.) into a traditional IRA. Where the investor has assets in such a plan but is no longer participating, rolling the assets into a traditional IRA is a tax free process.
Restrictions apply that may prevent contributions from being made.  Contributions amounts cannot exceed the actual amount of earned income.   Individuals covered by a company retirement plan may be partially or completely prevented from contributing pre-tax dollars to an IRA.

Special considerations for expats: American citizens not resident in the US may contribute to an IRA.  However, they must have earned income that is not excluded by the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion (FHE).  For example, an American citizen employed abroad by a foreign corporation earning USD 85,000 a year who is able to exclude all of her US income from taxation under the FEIE will have no “non-excluded” income from which to make an IRA contribution, and therefore cannot contribute.  A higher income expat with USD 200,000 of earned income who applies a combination of the FEIE and FHE with the Foreign Tax Credit to reduce their US tax liability will be able to make a contribution.   Of course, if the combination of FEIE, the FHE and the Foreign Tax Credit has eliminated all US tax liability, a traditional IRA contribution will provide no immediate tax benefit, but would be taxed when withdrawn in retirement and therefore is not advised.  (Instead, a Roth IRA contribution should probably be made in these circumstances, if permitted – see below.)

The “Roth IRA” Variant

The Roth IRA works in a reverse manner to the traditional IRA.  Contributions to a Roth IRA generate no immediate tax savings.  However, when distributions of both principal and earnings are taken in retirement, they are completely free of tax.  Contribution limits for Roth IRAs are the same as for regular IRAs.  There is also an option to convert an existing traditional IRA (as well as other tax-deferred retirement plans) to a Roth IRA.  All or part of the traditional IRA can be converted.  Conversion, however, requires the account holder to report the full value of the amount converted as regular income in the year converted (see further discussion below).

An important advantage of the Roth IRA is that it has no minimum distribution requirement.  The entire balance of the account can simply be left to grow free of tax and then bequeathed to heirs.  Those heirs, in turn, can stretch withdrawals out over their entire lifetime.  That realistically implies that Roth contributions made now by younger individuals could remain in the account, growing tax free for 100 years or more before being fully withdrawn.    The compounding effect of such long-term tax free appreciation implies a very, very large boost to inter-generational wealth accumulation.   Of course, leaving the Roth IRA untapped through retirement implies that the account owner has other financial resources on which to draw. 
Conclusion

Although specific analysis of each situation is required, most wealthy Americans will find the Roth contributions and strategically executed Roth conversions make sense.  The second article of the series looks more closely how to properly assess whether an existing traditional IRA should, or should not, be converted to a Roth IRA.

A full version of this article with all tables is available at www.thunfinancial.com

David Kuenzi is the founder of Thun Financial Advisors based in Madison, WI.

David Kuenzi, CFP®, Thun Financial Advisors
March 2010

David Kuenzi is a available to answer your questions as a financial expert on Expatica's Ask the expert section. 

Disclaimer: The views in this article are the writer's opinion as an investment advisor and do not necessarily reflect the views of Expatica.