Over the life of this blog, one of the most popular topics of discussion is Roth IRA contribution for US Expats. Specifically, I have answered a lot of the same questions in different forms around:
“Can I make Roth IRA contribution while taking Foreign Earned Income Exclusion?”
“Can I make Roth IRA contribution if my income is from a foreign employer?”
“Should I contribute to Roth IRA if I don’t plan to return to the US?”
“Do I have to pay taxes on my Roth IRA earnings in the country where I live?”
“What happens to my local taxes if I do a Roth conversion from my Traditional IRA?”
As we are approaching the April deadline for Roth IRA contribution once again, I think it’s fitting to finally pull all the info together in one comprehensive post. I hope this will help you make the right decision for years ahead.
US Expats Definition
This post is for US citizens and Green Card holders living overseas only. US citizens and Green Card holders are required to file and pay taxes on their worldwide income regardless of their location.
I will write a separate post next on Roth IRA contribution for US taxpayers who are not US citizens or Green Card holders – mainly visa holders living in the US or foreigners with US source earned income.
Comprehensive Guide of Roth IRA Contribution for US Expats
What is Roth IRA?
Roth IRA is a type of tax-advantaged retirement account in the US. What makes it a desirable saving vehicle for US taxpayers is its tax-free growth. As long as you meet the qualified distribution criteria, you do not have to pay US taxes annually on the dividends, interests, or capital gains generated, nor when you take a distribution from the account.
IRS Publication 590-A has the full rule around Roth IRA contributions if you wish to go over any detail not discussed in this post.
Who can make Roth IRA contribution?
Any US taxpayer with taxable compensation AND meet the Modified Adjusted Gross Income (MAGI) limitation can contribute to Roth IRA. For US expats, it doesn’t matter where the compensation came from since your worldwide income is subject to tax.
If you are married and filing jointly, only one spouse needs to have the taxable compensation to contribute to for both spouses.
What is the maximum I can contribute?
The maximum contribution is adjusted annually by the IRS. For Tax Year 2020 and 2021, the most anyone can contribute is $6,000. If you are at least 50 years old, you can make an additional $1,000 catch-up contribution, which makes the max $7,000.
How to calculate how much I can contribute?
IRS publishes a table annually to help you determine your allowed contribution amount based on your filing status and MAGI.
What to do if I take Foreign Earned Income Exclusion (FEIE)?
Taking FEIE does two things on your tax return.
First, FEIE reduces your TAXABLE compensation. As discussed, you can only make Roth IRA contribution if you have taxable compensation. If FEIE reduces your taxable compensation to zero, you cannot make any contribution. If you still have taxable compensation after FEIE, you can make contribution from that amount, but not over the maximum discussed above.
Second, FEIE is a MAGI add-back item. It means that the income limitation applies your total income before any deduction or exemption. Even if you still have taxable compensation after FEIE, your total income may be too high for you to contribute.
In summary, you can still make Roth IRA contribution if you take FEIE, as long as have taxable compensation above FEIE AND total income below Roth IRA income limitation.
Can I take partial FEIE so I have taxable compensation to contribute to Roth IRA?
Yes and No.
FEIE calculation is based on two tests, Bona Fide Residence Test and Physical Presence Test. Under Bona Fide Residence Test, you qualify by calendar year, so it’s all or nothing.
Under Physical Presence Test, you determine your eligibility based on any rolling 12-month period that intersects with the tax year. (See this post for more detail explanation.) Therefore, it is possible to find the right interval if you tend to come in and out of the US on short trips. However, you have to take the full amount you are eligible for if you choose to take it. It’s all or nothing.
Can I choose not to take FEIE so I have taxable compensation to contribute to Roth IRA?
You are not required to take FEIE even if you are eligible. However, if you have taken it in the past, you need to revoke your election of taking FEIE in the year you are eligible but choose not to take it. You will not be able to elect FEIE again within 5 years.
There are two circumstances where you may not need FEIE to reduce your US taxes.
First, if you have low income by US standard, you should calculate whether standard deduction, plus Child Tax Credit or Credit for Child and Dependent Care Expenses, already reduce your US tax to zero.
Second, if you pay more local taxes on the same earned income than you would have in the US, you should take Foreign Tax Credit instead.
If your income is at a range where you will pay more US taxes then local taxes on the same income, you may want to calculate how much additional US taxes you would have paid if you don’t take FEIE. Then make a judgement whether paying the additional tax upfront is worth the tax-free growth of the $6,000 contribution every year. If it’s $100 more, maybe. If its a few thousand dollars more, probably not.
Can I still make Roth IRA contribution if I have high income?
Yes, in a roundabout way. You can contribute to a Traditional IRA instead and convert Traditional IRA balance to Roth IRA at any time in the future.
There isn’t income limitation on Traditional IRA contribution. However, since your income is too high to take a deduction on Schedule 1, your contribution will be after-tax. This means that when you convert the balance to Roth IRA, only earnings and growth will be taxed. You need to report your after-tax contribution and Roth conversion on Form 8606 when you file tax return.
What if I already have Traditional IRA or Rollover IRA with pre-tax contribution?
You can still make after-tax Traditional IRA contribution. However, the tax liability when you convert to Roth IRA takes into account all of your Traditional IRA balance.
For example, let’s say you have $94,000 pre-tax contribution in a Rollover IRA from your old 401(k), and then opened a new Traditional IRA to contribute $6,000 this year. When you immediately convert $6,000 into Roth IRA, the taxable amount for the year will be:
$6,000*($94,000 / ($94,000 + $6,000)) = $6,000 * 94% = $5,640
As you can see, the conversion doesn’t really bring the same tax benefit if you already have large pre-tax Traditional IRA balance.
Nevertheless, if you have just a small Traditional IRA balance but will be high income for a long time, it’s still possible to produce long-term tax benefit if you make after-tax contribution annually but convert to Roth IRA systematically down the road. In addition to keeping track of the basis on Form 8606, I recommend opening a completely separate Traditional IRA to make after-tax contributions so you can distinguish the balances easily.
I can make Roth IRA contribution. But should I?
In my opinion, this is the most important question to ask. Just because you can do it doesn’t mean it’s necessarily the most beneficial in your situation.
We know that from the US tax standpoint, Roth IRA contribution (direct or roundabout) is a no brainer. For people with lower income, contributing to Roth IRA only costs them the taxes they have to pay at a lower marginal tax bracket. For people with higher income, they will have paid the taxes at the time of contribution regardless. Might as well put some in an account that won’t get taxed in the future.
Living overseas as a US citizen or Green Card holder means you are likely subject to two tax systems. The question is, will you continue to be subject to the same two tax system next tax year, the year after next year, and also in the future when you take distribution?
Only One Tax System
If you live in a country where you are not subject to tax at all, and do not expect to move anywhere else other than back to the US, then no extra consideration here.
Two tax systems and no expected change
You may be a dual citizen or expect to stay in one foreign country for the long-term. In this case, you should consider the Roth IRA treatment in your resident country.
No Income Tax Treaty or Treaty does not mention Roth IRA specifically
This condition applies to most countries in the world. Roth IRA is only mentioned specifically in eight US income tax treaties. When the Roth IRA tax-free is not recognized like in the US, you can be taxed in two possible ways:
- Treated as a normal investment account
- Distribution treated as a foreign pension income.
Depending on how your resident country treat reporting and taxation of foreign income and investment, Roth IRA may be great or may become a nightmare.
For instance, some countries don’t tax foreign income at all, even though they tax your earned income while you live there. In such case, your investment in Roth IRA may never get taxed.
On the other hand, some countries have higher tax on investment earnings than the US and also treat Roth IRA as a normal investment account rather than pension. Assuming you will continue to be tax residents in both countries, Roth IRA may just make your tax reporting complicated without any additional tax savings.
Tax Treaty deals with Roth IRA specifically
When Roth IRA is recognized in the treaty, it means its tax-free status in the US is reciprocated in the host country as long as certain conditions are met. Therefore, Roth IRA contribution may also be a good idea.
Two tax systems but expect to move
When your future tax residency is likely to change, the calculation becomes how to pick the best course of action facing uncertainties.
One constant for US citizens and Green Card holders is that you will always be subject to US taxes unless you expatriate. Optimizing US taxes is not a bad idea if you truly have an uncertain future.
If you do have an idea of your potential destinations and they are likely to be higher tax jurisdiction, it’s worth finding out how Roth IRA is treated in those countries before you contribute.
In summary, unless you are likely to stay in or move to a country that treats Roth IRA earnings or distribution unfavorably, Roth IRA contribution is generally a good idea if you are eligible.
What about Roth conversion on my existing Rollover IRAs?
Roth conversion is treated as type of rollover and a taxable distribution in the US. When you convert any Traditional IRA balance to Roth IRA, the part that represents pre-tax principal, earnings and gains will be taxed in the US.
As discussed early, most countries treat Roth IRA as a foreign pension or normal taxable investment account.
Under the former scenario, if the tax treaty specifically mentions the pension status will be preserved when you transfer an existing pension plan to another, then there will be no foreign tax due at the time of conversion. The points to consider around whether to convert to Roth are similar to those around whether to contribute to Roth IRA from income.
On the other hand, if the Roth IRA is treated as a normal taxable investment account, distribution from Traditional IRA at the time of Roth conversion will be taxed as pension income. Depending on how your local tax system treat foreign pension income and future foreign investment earnings, Roth conversion may or may not result in lower global tax liability in the long-term. This is the situation that will require further analysis.
I am considering giving up my Green Card. Should I consider Roth IRA contribution differently?
If you have NOT met the definition of long-term resident under Expatriation Tax rules, the considerations are similar to those who are in the US on work visa. We will address in another post.
Once you are a long-term resident, giving up green card creates the need to determine whether you are a Covered Expatriate. The full discussion around expatriation is beyond the scope of this post. However, if you meet the Covered Expatriate definition, your Traditional and Roth IRA will be treated as fully distributed the day before you hand in your Green Card. You will cease to enjoy the US tax benefits because you will no longer be a US tax resident.
Please comment below if I fail to address any major decision point. I’ll try to update the post as they come in. Please note that I won’t give advice on your particular situation. Thanks!