Many US expats utilize Foreign Earned Income Exclusion (FEIE) to lower their US tax liability. As US citizens, we have the privilege to support their government with taxes even when we do not live in the US. The good news is that if you genuinely established a home abroad and have met certain criteria, you are able to exclude a healthy portion of your earned income from taxation.
One of the downsides of claiming FEIE is that you are not able to contribute to an IRA with your excluded income. IRS has made that clear. In fact, even if you still pay taxes after exclusion, you are required to add back your exclusion to determine whether you are eligible for Roth IRA contribution.
If your full income is excluded from taxation, you are not allowed to contribute to another tax-advantaged account with the same income. This is considered double dipping.
But how about a 401(k) or other types of employer sponsored retirement accounts? This is a unique situation that applies to expats who receive income from a US-based employer, whether you are a salary employee, independent contractor, or self-employed business owner.
Under the same double dipping concept, you’d think that contributing to a tax advantaged account with excluded income is also disallowed. However, this is where the rule becomes confusing. An IRS specialist had expressed the opinion that under Revenue Ruling 70-491, FEIE income may not be contributed to retirement plans formed under Internal Revenue Code 401. However, others have argued that this ruling from 1970 was before 401(k) plans were established so cannot be applied on those plans.
From my research, I have not encountered a publicly written opinion from the IRS that specifically disallows contributing to a 401(k) with income that later gets excluded.
(Disclaimer: I am not a tax professional. Consult your tax advisor before you make any decision.)
Claim FEIE or Contribute to 401(k)
Practically speaking, the US taxpayer has to make the judgment call in advance. 401(k) contributions are generally made with each paycheck. The custodian does not know whether the participant will qualify for and claim FEIE or not. So, unless the taxpayer retroactively asks for the return of excess contributions, the custodian has no way to check.
Even if the custodian has the procedure for the return of excess contributions, it may be difficult for the taxpayer to ask for the return of the full contribution due to FEIE. It’s conceivable that custodians and plan administrators are used to adjusting the occasional administration errors. For example, you over contributed $100 because payroll did not catch it. I doubt the process would be as simple or even possible for a participant to claim the full contribution as excess.
So let’s say you have not yet contributed to a 401(k) in 2017, and it’s likely you will qualify for FEIE in 2017, how do you decide whether to contribute or not? This depends on which camp you are in.
Camp YES YOU CAN
If you are in the camp that you should be able to contribute to a 401(k) with your excluded income, then you are in for a potential large tax benefit.
Since a pre-tax 401(k) contribution is already excluded from income, there is less controversy. In effect, you are not paying any taxes now, but will pay it when you make distributions at ordinary tax rates in retirement.
The alternative is not contributing to a 401(k), but investing the same amount in a taxable account. You still will not pay income tax in the current year due to FEIE. However, you will pay taxes on dividends, interest, and capital gains. Given that long-term capital gains and qualified dividends are taxed at a lower rate than 401(k) distributions, it takes more analysis to determine which one is better under your unique situation.
The greatest tax benefit comes from contributing to a Roth 401(k), if you believe the IRS allows this. A Roth 401(k) contribution is supposed to be taxed when you file your current year return. However, if you claim FEIE, you will not pay income tax on your income, or, needless to say, your Roth 401(k) contribution. Therefore your Roth 401(k) contribution could never get taxed!
It is hard for me to see that the IRS will allow this after reviewing the rules. If you are audited and the contribution is deemed disallowed, you will then be subject to paying back taxes. My guess is that in practice it’s easier to disallow claiming FEIE then to make changes to your 401(k) contribution, so you may end up paying income tax on your full income.
Camp NO YOU CANNOT
If you agree with the 1970 ruling that excluded income cannot be used to contribute to a 401(k at all, then you have some decisions to make. Do you claim FEIE or not? Is the 401(k) contribution beneficial enough to not claim FEIE?
The first thing you need to know is that FEIE is not the only way to decrease your US tax liability while living abroad. For those of you who live in countries where local tax rates are higher, it may be more beneficial to claim Foreign Tax Credit (FTC) on the local taxes you pay.
If you claim FTC, then you are able to bypass the decision of whether to contribute to a 401(k). However, if your resident country does not tax your US earnings, then it’s likely FTC does not apply to you.
So, if you are solidly in the situation of deciding whether to exclude income under FEIE or contribute to a 401(k) for long-term tax benefits, I created a quick tool to help you make this decision. Under each option, you will see the final amount in real dollars you may receive, and the annual real rate of return.
Before you begin, note that the tool assumes that you distribute the full amount after the specified number of years. Obviously that may not be what happens in real life. However, it’s easier to compare the tax consequences using the uniform approach.
You need to make a few assumptions on the contribution and rate of return that will apply to your investments. Furthermore, you need to set an investment timeframe for comparison. I set it to be 30 years, which is the earliest I can take a lump sum from a 401(k) without penalty.
I chose 5% real return to represent a 100% equity portfolio. You are able to make your own assumption on the return. If you expect to invest in fixed income, then you will want to put in a share of return that will be taxed at ordinary tax rates.
Lastly, you need to make an assumption on the tax rate that will apply to your pre-tax 401(k) distribution.
Option 1: Take FEIE, No 401(k) contribution
The baseline is assuming you do claim FEIE, but invest the amount you would have contributed to a 401(k) in a taxable account. As explained earlier, you will have to pay taxes every year on the income, and on the gain when you sell the investment.
Option 2: Give up FEIE, Make a 401(k) contribution
If your employer offers a match, you may want to find out whether this “free money” is worth paying some taxes up front. This may be a good strategy if you don’t make a lot of money, but are able to contribute a large portion to a 401(k) because you don’t need the income to spend now.
You will need to know how much extra tax you may be paying due to not claiming FEIE. Unfortunately the calculation varies too widely for me to provide a reasonable estimate here for all users. However, you can easily find out the difference if you self-file using software like TurboTax.
In addition, you may also include the state tax and self-employment tax in this calculation to find out the true impact.
Option 3: Give up FEIE, Make a Roth 401(k) contribution
If your employer offers Roth 401(k) contributions, you may also want to know whether the forever tax-free treatment is worth paying some taxes up front. I assume that the employer match is still available, but will only be made on a pre-tax basis.
Now you know how the tool operates, let’s look at a couple of examples.
Example 1: Low income, high contribution
As mentioned, if you have a low US-based earned income but are able to contribute up to the max, the pre-tax 401(k) contribution may be able to eliminate most of your tax liability up front, and give you tax deferred growth on the investment.
Let’s say you only make $24,000 a year (or $2,000 a month). Making a full pre-tax employee contribution of $18,000 will cut your taxable income to only $6,000. Let’s assume you pay $1,000 extra in taxes overall for this income, which is about 16.7%.
In addition, your employer match is 100% up to 5% of your wage. So you also get $1,200 for free.
Look at Option 2 in the table below. If you contribute to a pre-tax 401(k), you will get a slightly lower rate of return due to the extra taxes you pay up front than claiming FEIE. However, at the end of the 30-year period, you actually will be able to take more out of your account. This is because you are paying your taxes out of your pocket now, not out of the investment account.
How about if you contribute to the Roth 401(k)? Let’s say you will pay $4,000 in taxes up front, which is also 16.7% of your $24,000 taxable income. You still get the $1,200 match from your employer on a pre-tax basis.
Look at Option 3 – your rate of return is actually slightly higher than claiming FEIE now and investing in a taxable account! This is because a Roth 401(k) gives you tax-free growth on your investment. At the end of 30 years, you will also have the most money after full distribution.
Example 2: Self-employed with High Income
Let’s say you own a consulting business with no employees in the US and made $100k in profit in 2017. By setting up a solo 401(k), you are able to deduct up to 25% of the contribution made to your pre-tax account from profit, which is $25k.
In this case, you will contribute $25k to your 401(k) as the employer contribution, $18k as an employee contribution, and leave $57k as gross income to calculate tax.
I used an online calculator to quickly estimate the tax consequences, assuming married filing jointly. Under option 2, you may have to pay $4,500 extra in taxes, while under option 3, the upfront tax bill goes up to $7,000. These upfront taxes diminish the long-term return compared to simply claiming FEIE now. Investing in taxable accounts in a tax efficient way may give you higher returns than using tax advantaged accounts.
Return assumptions make a difference
Note that what you invest in in a taxable account has huge consequences on the returns. This is because fixed income interest and non-qualified dividends are taxed at the ordinary tax rate.
You will see that for the previous two examples, if you set the % return coming from interest to be even just 20%, using the 401(k) becomes much more attractive, even if you have to pay taxes up front.
So before you look at whether to use a taxable or tax-advantaged account, evaluate your risk tolerance and how much you are willing and able to invest in more volatile assets like stocks with a potentially lower tax burden.
Download the tool here
In summary, claiming FEIE and / or contributing in 401(k) is a complicated issue. Consult a tax professional that specializes in expat tax planning, and don’t rely on your own interpretation. However, if you like analysis, here’s the tool I created. You are welcome to download it and play around with assumptions.