Having moved to the US after college, I know a lot of first generation immigrants who came to the US to pursue professional degrees or to work on their visa. Almost everyone, after getting the first paycheck, would have this same question – should I contribute to a 401(k) or IRA as a visa holder?
Should I contribute to 401(k) or IRA as a visa holder?
I’m going to assume that if you know to ask this question, you have a basic understanding of what 401(k)s and IRAs are. But here’s just a quick recap. Essentially 401(k)s and IRAs are types of US retirement accounts. In order to encourage people to contribute for retirement, the US government gives people incentive in the form of tax savings.
The tax savings come in two flavors. The first type you get it in the current year by taking a deduction against income so your contribution grows tax free until you retrieve it. When you take distribution in retirement, the amount is taxed as your ordinary income. This is generally called pre-tax or “traditional” contribution.
The second type of tax savings you get incrementally over the years. You pay taxes on the contribution upfront, but the retirement account balance is never subject to tax, either inside the account or when you take the distribution, as long as you meet a few requirements. This is called a Roth account or contribution.
Saving for your retirement and paying less tax are both good things. However, for visa holders, contributing to these types of tax-advantaged accounts often brings unwanted complexity.
By definition, visa holders, without pursuing permanent residency, will eventually leave the US and its tax claw. Is it wise to create long-term financial and tax ties in the US by contributing to a 401(k) and IRA? Is the current US tax savings worth it?
Since everyone facing this decision also has different circumstances, I believe the best way to help you answer these questions is to provide you with the steps to work through whether and how much to contribute to a 401(k) and IRA.
401(k) is an employer-sponsored retirement plan, but it’s not the only type. Depending on your workplace, you may be eligible to contribute to other types of defined contribution plans like 403(b) and 457 plans. Here I’m using 401(k) as a catchall term for all of them.
Here’s the decision flowchart that will help you walk through whether and how much to contribute to a 401(k). I’m going into detail below with each question in the orange box.
Q1: Does your employer match your contribution?
There are a lot of rules surrounding how employers may contribute to 401(k) plans for their employees to get a tax benefit. One common feature that many companies adopt is called “matching contribution.” It means that your employer will contribute separately on your behalf up to a certain percentage, as long as you contribute as well.
For example, let’s say that your annual salary is $100,000, and your company will match 100% up to 5% of your salary. It means that if you contribute 5%, or $5,000 of your salary to the account, your employer will give you an extra $5,000 in the account.
That’s pretty sweet, isn’t it? It’s an instant 100% return of contribution! You contribute $5,000, and the account balance becomes $10,000 after the match!
This is the reason why the first step of your decision is to find out whether your company matches your contribution. If it does, definitely take it up to the maximum. Even if some of it may be lost to taxes or penalties when you withdraw later, it’s still better than not getting it at all. It’s free lunch!
Q2: Do you have extra funds you wish to invest for 10+ years?
Before you figure out how much more to contribute to a 401(k) beyond the match, it’s important to plan for the amount you are able to invest in the market for the long-term. Once you decide on that amount, it’s a matter of whether to invest in a 401(k), or through some other types of accounts.
One common sentiment I’ve heard people express is that they may want to take the 401(k) money with them when they return to their home country to buy a house. If that’s something that might happen in the next few years, it may not be a sound idea to contribute your housing fund into the 401(k).
It’s important to remember that a 401(k) is designed for retirement use. That’s why it comes with the age restriction of when you can take it out without penalty. To maximize its return potential, you need to have a relatively long investment timeframe. Don’t invest your short-term goal savings in this account just because you can lower your tax bill now.
Q3: Do you plan to keep US tax residency for the long-term?
Perhaps the most important question to ask to determine whether you should contribute beyond the match is whether you intend to get a green card, or eventually become a US citizen.
The rationale is straightforward. If you will still be a US tax resident when you take the retirement distribution, then there’s no reason not to take the tax incentive now.
Note that as a green card holder, even if you move to another country, you continue to be subject to US taxes on worldwide income. If this is definitely not what you want, make sure you do proper exit planning from the US tax system. The longer you hold on to your green card, the more the wealth you accumulated might be tied to the US tax system. The US IRS will not let you off the hook easily.
Q4: Do you know which countries you may become a tax resident of when you take money from a 401(k)?
Q5: Do tax treaties make it more beneficial to invest in a 401(k) now?
As a rule, the US IRS will tax the pre-tax contribution in a 401(k), whether you are a US tax resident or not when you distribute. This is because the IRS gave up the right to tax you upfront already, so it will eventually come back to tax you, unless the tax treaty specifically says otherwise.
If the tax treaty says the US has the right to tax, then you pay taxes at the same rate as a US tax resident based on the total US income of the year.
If there is not a tax treaty, or the tax treaty specifies your new country also has the right to tax, you need to be extra careful to understand how you may pay taxes on the same income in two jurisdictions. In some cases, you may be able to claim a tax credit or deduction on the US taxes you’ve paid.
Lastly, if you simply don’t know where you will end up eventually, it’s easiest just to assume, at a minimum, the US will tax your 401(k) distribution based on total US income of the year.
Q6: Do you pay less tax now (US + Foreign) if you contribute to a 401(k)?
This is the main step that will determine how much you should contribute to a 401(k) beyond the match.
Let’s continue the example we started in Q1. You hold the job for five years, and then leave the US forever.
Each year you contribute $5,000 extra (on top of the $5,000 to get the match.) The contribution stops after 5 years when you leave. To avoid paying an early withdrawal penalty, you left the account to grow 5% a year for 20 years. Your account grows to be $58,873 by the time you can withdraw without penalty. This is the only effectively connected income you have in the US.
As a non-resident alien, you do not get the standard deduction on the tax return. Furthermore, the personal exemption was taken away starting in the 2018 tax year. So we can easily expect that most likely the entire $58,873 is subject to tax.
So now the question becomes whether to take it all at once, or in increments. Does that make a difference?
The answer is that it does, since the US has a progressive tax system. The higher the income you take in any year, the higher the tax bracket you might bump up against.
Let’s assume you remain a single taxpayer. Using 2018 tax brackets (caveat: without adjusting for inflation), you will only pay 10% on the first $9,525 you take out, and 12% on the next $29,174. Given the balance, it’s likely you can take all the money out by the age of minimum distribution and only pay 10% tax on the withdrawal. So overall you should get $52,986 back after taxes.
So what may happen if you choose to pay taxes upfront?
To make it simple, I’m going to assume you have an effective tax rate of 15% on the $100,000 US income right now.
To compare apples to apples, we need to assume because of the extra taxes, you can only contribute $5,000*(1-15%) = $4,250 to the taxable account. However, because it’s all in growth stocks that don’t pay dividends, it’s essentially growing tax-free when you sell as a non-resident alien.
After 20 years, growing also at 5%, the taxable account balance will be $50,042, so slightly lower than the after-tax distribution from the 401(k).
In this case, making that extra $5,000 contribution in 401(k) instead into a taxable account may be a good decision.
As you can guess by now, the fact that you can avoid 15% taxes upfront and only pay 10% when you distribute is the main reason why contributing extra to a 401(k) is a good idea. Depending on your income and work history in the US, it may not be the case for you. Plus the US tax code may change in the future, so take all the analysis with a grain of salt.
Q7: Is the estimated tax savings now worth the administrative cost?
While in theory there may be potentially a tangible benefit to contribute extra to a 401(k), you need to also consider the cost to extract the benefit.
File for Refund
As you might soon learn, in the US your tax liability is not always the same as withholding. The US government has the incentive to withhold more so you will file a tax return for a refund.
For a 401(k) distribution, the IRS requires the custodians to withhold at a 30% flat rate in the absence of a lower treaty rate. This means that you will likely have to file tax returns to get the money back. If you are able to do it on your own, great; if not, then there is extra cost to hire a tax return preparer.
Dealing with Plan Administrator and Custodian
As mentioned in this previous post, many custodians do not like the extra scrutiny and regulations they need to comply with in order to service foreign clients. While they may not be able to kick out a 401(k) participant, your 401(k) may not be around forever. If the company closed, or switched plans, they may be able to force out the old participants. Another potential scenario is that you have too small a balance in the plan and they may force you to transfer the balance to an IRA.
In this case, you will need to find a custodian that will take an IRA that is titled to a foreign owner. While it may all end up alright, if this happens, it’s likely to take a lot of time and energy to deal with this from afar and with a time difference.
Change of Tax Law
This is the one thing no one can expect. The law might change in your favor or against your favor, and we are talking about in 20 or 30 years. There is an opportunity cost of letting the IRS have a hand on our investment for the long-term when you can choose not to, especially when the tax saving over time isn’t particularly high for your situation.
Eventually, you need to compare the benefit from Q6 and cost from Q7 and make a judgment call.
How about Roth contributions?
So far we’ve only considered making pre-tax contributions. You may be wondering whether a Roth contribution is right for you, since all of your American colleagues do it.
My answer to that is given you don’t get any tax benefit now, a Roth contribution is not particularly beneficial should you leave the US in the future.
As I’ve alluded to in a previous example, if you will become a non-resident alien, you do not pay capital gain taxes when you sell your investment. This in effect makes contributing to Roth type accounts a moot point. It is very likely that you are able to structure your investments to pay minimal taxes on your taxable investments, unless you somehow become a US tax resident again. So there is not a great reason why you would want to tie your investment down in an account subject to more rules.
So how about an IRA?
If you have access to a 401(k), you will not be able to get an extra current year tax benefit by contributing to an IRA. While you are able to contribute to a Roth IRA if you meet income requirements, or to a Traditional with basis, they do not offer you the tax benefit now.
As we discussed in the previous Roth section, contributing fully taxed dollars into IRA may not give you much more tax advantage if you will leave the US eventually.
Do not have access to 401(k)
If you don’t have access to an employer plan at work, you are able to contribute to an IRA and take a deduction on your tax return in the current year. If this situation applies to you, you can start with Q2 of the decision flow chart in the 401(k) section.
However, make sure you pay extra attention to the tax treaties. While many countries treat a 401(k) as an employer pension, an IRA is often in the legal gray area. If the treaties do not specifically cover IRAs, it’s possible your IRA might be treated as a normal taxable account in your home country. If there is no treaty, it’s even more likely the tax-deferred status may not be recognized.
I hope this tool help you decide whether and how much to contribute to a 401(k) and IRA. Given all the unknowns in the future, hopefully it will still get you closer to making a sound decision, if not a precise one.