If you’re living abroad and operating a business in a low tax country, and your income exceeds the Foreign Earned Income Exclusion, you might consider setting up a US compliant IRA, ROTH, or SEP. Here are the IRA and ROTH contribution limits for expats and how to structure your retirement account.
Let’s start from the position that one should only set up a US retirement account if it will help to reduce your US tax bill. That means you can consider a US IRA or ROTH if you’re working in a country with a lower tax rate than you pay in the United States.
For example, let’s assume your US personal income tax rate is 30%. If you’re living the the UK, and earn £150,000, your UK tax rate will be about 40%.
Because your UK rate is higher than your US rate, you will pay no taxes to the US. The foreign tax credit will allow you to deduct or exclude the taxes paid to the UK so that you owe nothing to the IRS.
Next, let’s say you earn that same salary but are living in and working in the Cayman Islands. Cayman has no personal income tax, thus you pay zero to your country of residence.
This means that your foreign tax credit in the United States is zero and the IRS will tax your $150,000 at 30% unless you can take the Foreign Earned Income Exclusion (see below) and reduce your taxes by contributing to a US retirement account.
The same can happen if you’re running a business in a country that doesn’t tax foreign source income, only local sourced income. For example, you’re operating a business from Panama that sells products or services online to customers in the United States.
You have no local sourced profits in Panama because you’re not selling to locals. So, your corporation pays no tax in Panama.
You then take a distribution from this company, which is also not taxable in Panama. You report that to the IRS as salary from your offshore corporation. You pay nothing in Panama and the US wants 30%.
The big exclusion should be using is the Foreign Earned Income Exclusion. If you’re a resident of a foreign country, or you’re out of the US for 330 out of 365 days, you can exclude your first $102,100 of salary from your US taxes.
That is to say, if you earn $150,000 in salary while living and working abroad, the first $100,000 is tax free in the United States. Therefore, you pay US tax only on the remaining $50,000. If you’re salary is $300,000, you will pay US tax on the remaining $200,000 (assuming no foreign tax credit).
If you don’t qualify for the FEIE, you definitely want to set up an IRA or similar plan. Higher income expats might consider a defined benefit plan that can be converted into an IRA.
If you will contribute to a ROTH, you also need to watch out for the income limits. For 2016, they were as follows:
Roth IRA Income Limits (for single filers): Phase-out starts at $117,000; ineligible at $132,000
Roth IRA Income Limits (for married filers): Phase-out starts at $184,000; ineligible at $194,000
To calculate your limits, you must add back in your FEIE amount of $100,000. Keep in mind my position is that an IRA and a ROTH only makes sense if you get a tax benefit.
Therefore, only a single person that earns more than $100,000 and less than $132,000 would ever use a ROTH. Likewise, a family where only one spouse is working would use a ROTH if that person earned more than $100,000 and less than $194,000.
In a case where both spouses are working, both earn about the same amount, and both qualify for the FEIE, you would never use a ROTH. Each spouse can exclude their first $100,000, for a total of $200,000, which is over the AGI limit of $194,000.
If you’re working for someone else, you probably can’t manipulate your salary… you want to earn as much money as possible, taxes be damned. If you’re operating your own business, you can usually decide how much to take out as salary and how much to leave in the corporation as tax deferred retained earnings.
As a business owner, your first priority is to maximize the Foreign Earned Income Exclusion. You should ALWAYS take out the FEIE of $100,000 single and $200,000 when both spouses are working in the business. I can’t think of any situation where you would take out less if the cash is available.
If you’re single, and you can live off of $100.000 a year, then leave the balance in the corporation tax deferred. If you need to take out more than the exclusion amount, you can earn a salary of $129,000 and receive some benefit from a ROTH.
- Remember that these modified AGI limits apply to ROTHs and not traditional IRAs
I hope you’ve found this article on IRAs and ROTHs for expats to be helpful. For assistance structuring your business offshore, please contact us at firstname.lastname@example.org or call us at (619) 550-2743. All consultations are free and confidential.