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 second of two articles written for Expatica that look at the proper use of retirement accounts for Americans living abroad.  In the first article, ’What American Expats Need to Know about IRAs and Roth IRAs for Retirement Planning Purposes’, we discussed the difference between the Traditional IRA and the Roth IRA and how Americans abroad can take full advantage of these tax advantaged retirement accounts. In this article we consider under what circumstances an American expat should convert their existing IRA to a Roth IRA.
 
2010 rule changes

The benefits of Roth accrue mostly to wealthier tax payers who will find themselves in high marginal tax brackets during their retirement years.  However, most well-to-do tax payers have until now not been able to benefit because individuals with modified adjusted gross income of above USD 105,000 (or for those "married, filing jointly", USD 176,000) have not been able to contribute to a Roth IRA.  Furthermore, all taxpayers with modified adjusted gross income above USD 100,000 have been prohibited from converting traditional IRAs to Roth IRAs. Starting in 2010, these income limits end. Millions of upper-income Americans previously shut out of Roth will become eligible.

Special considerations for expats: Many American expats who have married non-Americans elect to file "married, filing separately".  Until now, taxpayers using this filing status have been prohibited from converting traditional IRAs to Roth IRAs.  Beginning in 2010, that restriction ends.

To convert or not to convert?

Conversion of a traditional IRA to a Roth IRA requires the account holder to report the entire amount converted as regular income in the year of the conversion. That may result in a very large tax bill due at the time of conversion for individuals who have accumulated large IRA accounts.

Generally, it is better to pay taxes later rather than sooner.  However, under the right circumstances, the Roth conversion (and/or annual contributions) allows for the payment of taxes now at potentially lower rates than if the funds were withdrawn in retirement.  The Roth also allows all future appreciation to be totally tax free.  The value of these benefits may more than offset the negative impact of having to pay the tax currently.  The calculation of whether or not it makes financial sense to contribute to a Roth IRA or convert a traditional IRA to a Roth IRA largely depends on two variables: 1) The marginal tax rate at which taxes will have to be paid on amounts converted or contributed now, 2) the marginal tax rate prevailing at the time money is withdrawn from the traditional IRA, if conversion is not carried out.  Analysis shows that when retirement tax rates are expected to be the same or higher than current rates, the Roth contributions and Roth conversion is unambiguously the right choice.  Only when marginal tax rates in retirement are expected to be substantially lower than current marginal tax rates does the traditional IRA prove optimal.

Judging current and future tax rates

Determining current and future tax rates is a complex exercise.  First, we obviously cannot have complete certainty about tax rates far in the future.  Second, good financial planning can help reduce tax rates now and in the future which in turn will alter the pay-off of employing Roth. 

Proper calculation of the current marginal tax rate. Marginal tax rate refers to the rate at which your last dollar of taxable income is taxed.  This can range from 10 percent for individuals with less than USD 8,375 of taxable income in 2010 to 35 percent for individuals with more than USD 373,650 (these rates are set to rise in 2011).

Taxpayers considering a Roth conversion must be aware that conversion may raise the marginal tax rate at which at least some of the converted amount is taxed. For example, an individual with taxable income of USD 110,000 in 2010 falls into the 28 percent marginal tax bracket.  If he has a USD 100,000 traditional IRA to convert and converts all of it in 2010, the effect of the additional income will be to push him into the 33 percent marginal tax bracket, causing part of the converted amount to be taxed at the 33 percent rate and part at the 28 percent rate.  In such cases, it may be optimal to spread the conversion out over several years so that the conversion itself does not push the taxpayer into a higher tax bracket.  Careful analysis of an investor’s tax situation is required. 

Special considerations for expats:   Expats have to go through the same process of estimating current versus future marginal tax rates, but their calculation includes a few extra factors.  For example, State taxes are an important part of the Roth conversion calculation for Americans abroad.   In many cases (but not all) Americans living abroad are not subject to state taxation.  If they intend to return home and retire in a state that taxes traditional IRA distributions (as most states do), then the ability to convert without paying state taxes on the conversion (and thereby permanently removing the assets from both state and federal taxes) effectively lowers the bar in favor of conversion.  Host country taxation must also be considered.   If the Roth IRA conversion amount is subject to a local taxation at a higher rate that the applicable U.S. rate, it may be better to defer conversion until returning to the U.S. if return is anticipated.

The myriad of circumstances and possibilities raised by living abroad are too many, and too specific to each individual case to list completely here.  Suffice to say, the Roth conversion decision requires careful consideration and the required analysis is further complicated by additional financial planning factors unique to Americans abroad.

Tax diversification

For many younger taxpayers or the merely moderately well-off, making a close to definitive conclusion about whether conversion is financially optimal may not be possible.   There can be too many uncertainties about retirement year financial circumstances for an accurate calculation to be made.  This is one of the reasons that taxpayers may want to pursue a strategy of “tax diversification.”   In this scenario, the taxpayer contributes some annual amounts to a Roth and some to a traditional IRA.  Likewise, part of an existing traditional IRA is converted and part is not.   This approach effectively hedges the taxpayer against the risk of being in a much higher or lower marginal tax environment during retirement than they anticipated when they made the decision between traditional and Roth.

Special considerations for expats:   Tax diversification makes especially good sense for Americans abroad because the complexity of the conversion calculation is augmented by their special tax and planning circumstances.  The more complicated the calculation, the higher the risk that the wrong decision will be made and therefore the greater the benefit of a “hedged” approach as offered by the tax diversification strategy.

Conclusion

Although specific analysis of each situation is required, most higher-income Americans will find the Roth contributions and strategically executed Roth conversions make sense.  For taxpayers not expecting to be in the higher tax brackets during retirement, the decision is not clear-cut.   Status as an American expatriate will have great impact on the calculation.  As always, it is best to consult with a qualified investment advisor or tax consultant before making a final decision.

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

David Kuenzi, CFP®, Thun Financial Advisors
December 2009--updated January 2012