What are IRAs and Roth IRAs?

Retiring and living abroad can offer many advantages, such as the ability to travel, lower cost of living, and the opportunity to immerse yourself in new cultures. For Americans relocating overseas, selecting the appropriate retirement accounts is an important decision.

In the United States, we have a variety of financial tools at our disposal for saving towards retirement. Some of these can be initiated independently, while others are accessible exclusively through employment. IRAs and Roth IRAs are excellent choices because they are available to all taxpayers with earned income.

Contributions to IRAs can reduce taxable income during working years, allowing investment earnings to accumulate on a tax-deferred basis. Later, distributions in retirement are taxed as ordinary income. As retirees typically have a reduced tax liability during retirement, this creates a positive tax arbitrage. On the other hand, contributions to Roth IRAs are made with post-tax dollars, but the future growth and distributions are tax-free. As you can tell by now, both IRAs and Roth IRAs have tax-based incentives to save for retirement in the US.

Managing finances when your financial circumstances extend across international borders introduces a high level of complexity to financial planning and tax planning. US expats living in foreign countries with their own sets of rules and tax regulations often find it challenging to know the treatment of IRA and Roth IRA accounts, and whether or not to make further contributions. Let’s explore a few examples to illustrate these difficulties and review the solutions.

Should You Contribute to IRAs when Residing Abroad?

All US taxpayers with IRAs and Roth IRAs must follow specific IRS guidelines for contributions, reporting, and withdrawals in order to preserve their tax-advantaged status and to avoid unnecessary taxes or penalties in the US. Nevertheless, US expats residing in foreign countries must also take into account the local tax consequences of making contributions or taking distributions from one of these accounts.

Traditional IRA contributions offer the benefit of potentially allowing the deduction of the contribution amount from taxable income. However, it’s worth noting that many US expatriates working in foreign countries utilize the Foreign Earned Income Exclusion to exclude the first $120,000 of their earned income from US taxation. To qualify for deductible IRA contributions, it is necessary to have income that is not excluded or income exceeding the exclusion threshold.

In addition, high-income earners living in high-tax countries like Germany, typically have the option of using foreign tax credits to offset their US tax liability on the taxable income not excluded by the Foreign Earned Income Exclusion (FEIE).

In this specific scenario, while technically making an IRA contribution is possible, it is generally not advisable. This is because the contribution would be made with after-tax dollars, and at withdrawal, those contributions would be subject to taxation again. This results in double taxation of contributions and distributions, making it a significant pitfall to avoid for US expatriates.

In contrast, when residing in a low-tax country or a country with territorial taxation like Singapore or Honk Kong, US expats effectively become net US income taxpayers. In this case, decision-making regarding contributions to IRA and Roth IRA should be based on the evaluation of the current income and tax bracket level, as well as the anticipated income and tax bracket level during retirement.

Under certain circumstances, making an IRA contribution can prove advantageous if it results in a reduction of foreign taxable income. While many countries will honor the tax-deferred status of IRA accounts (either explicitly via an income tax treaty, or through a practical treatment by local tax advisors), most do not permit foreign taxable income reduction through contributions made to these accounts. However, there are exceptions. For instance, in certain circumstances, Switzerland, which has a unique arrangement with the United States through an income tax treaty, permits the deduction of contributions made to US IRAs from Swiss taxable income.

The United States has established income tax treaties with 66 countries, but it’s crucial to recognize that these treaties can vary significantly. Many of these agreements were signed decades ago and may not offer precise guidance for every type of income or account. To ensure the success of your financial plan, it’s essential to have a clear understanding of which accounts are included and excluded under specific tax treaties.

How are the IRA Distributions Taxed when Living Abroad?

Now, let’s explore how IRA distributions are taxed when living in a foreign country. In a country with a high-tax environment and a system that taxes global income, individuals are likely to face higher tax obligations on their IRA distributions in that foreign country.

However, there are some countries that have advantageous tax treaties with the United States, as is the case with France.

Unique to their tax treaty with the US, US citizens living in France and receiving IRA distributions will only be subject to US taxation, which typically comes with lower tax rates than those in France.

Are Roth IRAs a Good Idea for US Expats?

Roth IRAs are an excellent choice for someone whose current tax rate is equal to or is lower than their expected tax rate in retirement. It’s worth noting that Roth IRAs were established in 1997, which is long after many tax treaties were signed. As a result, Roth IRAs are only explicitly mentioned in a few tax treaties. Nevertheless, some countries, including the United Kingdom, Canada, France, Belgium, Latvia, Lithuania, and Estonia, do recognize the tax-deferred nature of Roth IRAs.

Residing in one of the countries mentioned above, a low-tax country, or a country with territorial-based taxation, contributions to Roth IRAs can be advantageous (except Canada). The Roth nature of the account with the tax-free future growth can be recognized by these countries. However, it’s essential to understand that mere eligibility for Roth IRA contributions does not necessarily mean it’s the right choice for you. Your decision should depend on a careful assessment of your present income and tax rate compared to your anticipated income and tax rate during retirement.

Given that only a few countries acknowledge the tax-deferred nature of Roth IRAs, it’s critical to
understand that the majority of other countries, that do not recognize Roth IRAs, will typically impose taxes on them either annually based on the account’s mark-to-market value or on the income and dividends earned within the account and distributions. Or even worse, will fully tax the distributions as ordinary income.

Last Thoughts

If you are an executive working in a foreign country and are covered by your employer’s tax equalization agreement, some of the points discussed in this article may not be applicable to your specific situation. Our team has expertise in providing guidance on these types of agreements, ensuring that you make the most advantageous decisions regarding your retirement savings.

As a US expat living in a foreign country, you might encounter certain challenges when it comes to maintaining your US-based IRA and Roth IRA accounts. At Cerity Partners, our cross-border team works with several expat-friendly custodians who allow you to keep your US IRAs and Roth IRAs, even while living abroad.

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