If you are a self-employed American expat, you may be wondering what is the best way to save for retirement. As a US citizen, you are well aware of the US tax liability that follows you for the rest of your life. Short of giving up citizenship, what can you do to minimize the tax you need to pay now and in the future?

You may be happy to learn that you are still able to make 401(k) contributions as a self-employed American expat. However, it comes with a few conditions:

1. You need to have non-excluded income.
2. If you have employees, you need to create a 401(k) plan that also benefits your employees, which comes with more rules than simply contributing for yourself.

Does it make sense for you to make 401(k) contributions as a self-employed American expat?

As discussed previously in the FEIE vs 401(k) decision post, many expats may not have foreign income above the exclusion amount to be able to contribute to a 401(k). In this case, you need to decide at your income level and filing status, whether taking FEIE or contributing to a 401(k) gives you lower tax liability over the long run.

For self-employed people, however, there is one more wrinkle.

If you are self-employed, or filing Schedule C with your tax return, your business expense is considered a deduction that is allocable to excluded income. This means that you may not be eligible to take the maximum $104,100 (at 2018 level) FEIE, even if your business profit is below that amount.

Example 1

For example, let’s assume you had gross revenue of $100,000 in 2018, and $10,000 in business expenses. This gives your Schedule C profit at $90,000, lower than the maximum available at $104,100.

Subsequently, the exclusion amount is reduced in proportion to the deduction attributed to the excluded income. In this case, the deduction includes:

$10,000 in business expenses, AND

Deductible half of the self employment tax = 7.65%*$90,000 = $6,885

Total Deduction = $16,885

Your eligible FEIE can never go above the gross revenue, which is $100,000 in this case. So the final FEIE you can take = $100,000 – $16,885 = $83,115.

And the final non-excluded income = $90,000 – $83,115 = $6,885

In essence, $6,885 of your profit is included as non-excluded gross income.

You may be thinking, “That is not fair!” Your friends who are employees get to take the full exclusion! Nevertheless, this actually presents a great planning opportunity.

Let’s say you are single. In 2018, you will have a $12,000 standard deduction. After the self-employment tax deduction and standard deduction, you will effectively have no taxable income, so you don’t have to pay any federal income tax. On the other hand, you have non-excluded gross income, so you can contribute to a 401(k).

You might get where I’m going with this. If you contribute $6,885 of your non-excluded income to a solo Roth 401(k), the contribution in effect will never be taxed in the US!

Of course, you might need to pay taxes in another country, so you still have to do the analysis on whether FEIE or Foreign Tax Credit is better for you. But overall, self-employed American expats have an added advantage to shelter more future income from taxes. (Here’s another post I talked about tax-free investment income for American expats.)

Contributing to a Traditional 401(k) is more complicated

Since a Traditional 401(k) contribution is another deductible item that is attributed to excluded income, it takes additional calculation to decide whether there will be sufficient tax benefit in doing so.

Example 2

Let’s say in this new example, your gross revenue is $140,000, and business expense is $50,000. Your net profit is still $90,000, but your tax liability and 401(k) contribution opportunity looks completely different.

Your total deduction attributed to excluded income is:

($90,000*7.65% + $50,000)*($102,100/$140,000) = $41,485

Your FEIE in this case will only be $102,100 – $41,485 = $60,515.

And your taxable income will be $90,000 – $60,515 – $6,885 – $12,000 = $10,600

Even though you only take home $90,000, you still have taxable income that will be taxed in the higher marginal bracket!

So at this point, you may be thinking, how about I contribute pre-tax to a 401(k)? Will that allow me to shelter more income from taxes this year?

As a solo entrepreneur with no employees, you are allowed to contribute both as an employer and as employee. You still have an $18,500 cap for the employee portion (assuming you are younger than age 50, so no catch up contribution).

The calculation for the employer portion is slightly more complicated. (You can read more about it here.) For this exercise, let’s just jump to the conclusion – you are able to make a maximum $18,000 contribution for the employer portion.

Example 3

So overall you thought you can further shelter $36,500 from income tax. Interestingly, a pre-tax 401(k) is also a deduction that will lower the FEIE available. By putting $36,500 in a pre-tax 401(k), your new FEIE actually decreases:

$102,100 – ($90,000*7.65% + $50,000 + $36,500)*($102,100/$140,000) = $33,996

And your new taxable income becomes:

$90,000 – $33,996 – $6,885 – $36,500 – $12,000 = $619

So by putting $36,500 in a pre-tax 401(k), your taxable income is only reduced by roughly $10,000. Not the effect you would expect.

Nevertheless, you only have to pay taxes on $619 income, which is much better. On the other hand, remember that you need to pay taxes when you distribute from a 401(k). You may want to use my tool to determine if the tax savings now is worth it in the long-term.

What if I don’t declare business expenses?

You might notice, the higher the business expense you declare, the lower the FEIE becomes. That doesn’t seem right. What if I simply don’t declare expenses, since FEIE is based on gross revenue?

Continuing with the previous example, if you don’t declare business expenses, you will need to pay both income and self-employment tax on a greater base. However, on the part of social security tax, you only pay taxes on the first $128,400 income (at 2018 level).

Example 4

Repeating the exercise, your new FEIE becomes:

$102,100 – ($128,400*6.2% + $140,000*1.45% + $36,500)*($102,100/$140,000) = $68,196

And the new taxable income becomes:

$140,000 – $68,196 – $9,990 – $36,500 – $12,000 = $13,314

So not reporting expenses does not help you after all. Overall expenses still lower the base you need to pay taxes on, because expenses only partially decrease your FEIE.

New 20% deduction for small business owners

Starting in 2018, the new tax law allows certain small business owners to take an additional 20% deduction below the line. It means that this new deduction may not impact how much FEIE you are allowed to take.

So far the new law has not been interpreted on a real tax form, so it’s difficult to tell how your 401(k) contribution plan might be impacted. Nonetheless, it’s likely that more of your foreign income will be tax-free after deductions. The more you can put current tax-free income into a tax-free or tax-efficient investment account, the better.

What if I don’t even want to pay self-employment tax?

I know some expats may be thinking, even if I’m not paying US income tax, I’m still paying 15.3% of my income into Social Security and Medicare. Who knows if I’d ever get any benefit from those programs!

If you are a long-term American expat who want to escape the US tax system as much as possible, short of expatriating, you may want to consider incorporating overseas. There are pros and cons of doing so, either in your resident country or even in a third country (so called “tax havens”.)

If you are simply drawing a salary from a foreign company, you will report your income as an employee of a foreign company, where you do not pay into the US social security system. Instead, you may want to explore your obligation or benefits in participating in the local system.

In addition, if your income is greater than the maximum FEIE, you still need to pay taxes on the excess amount.

Lastly, since corporate structures overseas are not always compatible with the US, you may find that you create extra US reporting requirements by incorporating overseas. I recommend working with an attorney on this.

What if I have employees?

As mentioned earlier, normally if you have employees, you need to design and administrate a 401(k) that does not discriminate against them. However, what is important here is whether your employees are considered “eligible employees”.

To maintain a qualified plan, you may generally exclude certain employees from your plan:

1.    Employees under age 21
2.    Part-time employees working less than 1,000 hours  a year
3.    Nonresident alien employees

As a small business owner living overseas, you may only have non-US employees. This means you may still start a solo 401(k) that excludes them. However, it may require working with a 401(k) plan specialist to make sure the plan language appropriately spells out your situation. Also, you need to make sure you still follow your local employment laws.

Summary

In summary, here’s comparison of the example above.

It is likely you will need to do several iterations to determine how to make 401(k) contribution as a self-employed American expat. Your gross revenue and business expense both have great impact on what strategy is best for you. Also you may have spousal income and dependent related tax benefits. Work with a tax preparer who is willing to run different scenarios for you, or use a tax software, to maximize your long-term tax benefit and investment.

At this point, it’s also worth mentioning that there are types of retirement account that might work for self-employed individuals at different income and employee level, such as SEP IRA, SIMPLE IRA, or even just a plain IRA / Roth IRA that is not associated with your business. Perhaps it’s for another post to discuss how you should choose based on your circumstances.