No one wants to pay tax- not now or in retirement. Living and working overseas may entitle US taxpayers to exclude some or all of their income from taxation under the Foreign Earned Income Exclusion (FEIE). This element of US tax code can be hugely advantageous for expats. However, one major downside is that claiming this exclusion may prohibit taxpayers from the making contributions to tax advantaged retirement accounts- such as a Roth IRA. This week, we’re going to explore an obscure loophole in the US tax code that may help American expats who already have pretax retirement savings convert these savings to a Roth IRA and receive the funds tax free in retirement.
What is the FEIE?
The FEIE allows US taxpayers to exclude the money that they earned working overseas from US income tax. The amount of the FEIE for 2019 is $105,900. This means that expats who qualify for this exclusion can exclude up to $105,900 from their US income tax, provided this money was earned abroad. This does not entitle claimants to exclude investment income, such as dividends or rents. It must be earned income. There are two way to qualify for the FEIE. 1) The Physical Presence Test- having spent 330 days or more outside the US. 2) The Bona Fide Residence Test- being a bona fide resident of a foreign country. Check with a CPA to see if and how you qualify.
What is an IRA?
An IRA is a tax advantaged retirement account. Americans can contribute funds to either a traditional IRA or a Roth IRA. There are other types of IRAs, but for the purposes of this article, we’ll focus on these two.
A traditional IRA is a retirement savings account that allows for contributions of up to $6,000 per year. Contributions are tax deductible. For example: If you earn $50,000 and contribute the maximum ($6,000), you will start with taxable income of $44,000 before deductions or exemptions. The money in this account grows tax free. That means any gains on your account will not incur an income tax liability until you are ready to withdraw them. Check with a CPA on required minimum distributions (RMDs). When you do withdraw the funds in retirement, they are taxed as ordinary income. The easiest way to think about this is- TAX-FREE ON THE WAY IN & TAXABLE ON THE WAY OUT.
A Roth is just the opposite. The money goes in after tax. So, in the same scenario presented above, you would still start with a taxable income of $50,000. The money would still grow tax free. However, you would now be able to withdraw the money tax free. For those who are eligible to contribute, I am a huge fan of Roth IRAs right now. Tax rates are low. I think it’s a great opportunity to pay these relatively lower tax rates now and receive the income tax free in retirement. To sum up, ROTH = TAXABLE ON THE WAY IN & TAX-FREE ON THE WAY OUT.
The FEIE & IRA Contributions
The downside of the FEIE is that the income that is excluded can not be contributed to either type of IRA. In most cases, if you are claiming the FEIE, you won’t be making IRA contributions. There are a few exceptions. If you earn above the FEIE limit ($105,900) but less than the Roth IRA contribution limit ($122,000), you can contribute the maximum of $6,000 (all 2019 figures) to your Roth. However, this leave a very narrow earnings window. After $122,000, the amount you can contribute to a Roth is gradually phased out until you reach $137,000. If you’re earning above this income threshold, you can’t contribute to a Roth. Traditional IRA contributions may still be possible on earnings that exceed the FEIE ($105,900). However, check with a CPA on the tax deductibility of these earnings. While most digital nomads are not covered by an employer retirement plan, be sure to mention if you are, as this may reduce what you can contribute.
Where the Magic Happens
The benefits of a Roth are clear. You get tax free distributions in retirement and the money grows tax free until that point. Your pretax retirement accounts (traditional IRA or traditional 401k) will likely be taxable income in your retirement. But what if you could covert these traditional savings accounts into Roth IRAs? You may be able to by utilizing the FEIE. Let’s take a look at this example.
Jane lives and works as a digital nomad. She has $40,000 in a traditional IRA.
She earns $35,000 USD per year teaching English online.
She qualifies for the FEIE under the physical presence test and excludes all of her income for US tax purposes.
She is a single filer and can take a $12,000 standard deduction.
She doesn’t have any income to offset against this deduction because the FEIE has already made this income tax-free.
She can roll $12,000 of the $40,000 in her traditional IRA into a Roth. This rollover has tax consequences. However, the standard deduction will wipe out any tax liability on this income.
Her money continues to grow tax-free and now SHE CAN WITHDRAW THIS MONEY TAX-FREE IN RETIREMENT.
IRA rollovers are a bit complex. Check with a CPA on your specific tax situation to see if you qualify and are able to use this strategy. Be aware that if you do convert these pretax retirement accounts to a Roth, you will not be able to withdraw the funds for a specified period. Speak to a CPA to get the specifics related to your situation. The ability to roll funds into a Roth IRA tax-free is a huge advantage to claiming the FEIE. Being a digital nomad is an awesome lifestyle. However, setting yourself up for a stable financial future is equally awesome.