How to Avoid Taxes With Roth IRA Conversions
Roth conversions are one of the most effective investment and tax planning tools available to U.S. taxpayers. However, for Americans living and retiring abroad, this strategy may or may not work, depending on where they live when making withdrawals. This article uses a question-and-answer format to examine the advantages (and disadvantages) of Roth conversions for Americans living abroad and explains when and how the strategy can be used effectively to avoid taxes with a Roth IRA conversion.
Please refer to our companion research articles for a background on expat retirement accounts and how a Roth conversion can help U.S. expats planning to return to the U.S. avoid state taxes.
Q: What is a Roth conversion?
A: Conversion of pre-tax deferred income held in a qualified U.S. retirement account, like an IRA, a 401k or a 403b, to after-tax, tax-exempt income in a Roth IRA account.
Q: What are the main advantages of a Roth conversion?
A: It effectively locks in current tax rates on your deferred retirement income. Additionally, the money grows tax-exempt, so you avoid taxes on future gains. Generally, a good rule of thumb is that Roth conversions make sense if your tax rates in retirement will be as high or higher than your current tax rates. This is especially true if you’re moving to a relatively high tax area like Europe; doing a Roth conversion prior to moving locks in low U.S. tax rates, assuming your new country recognizes Roths. See below for details.
Q: Are there other advantages?
A: Roth conversions:
- Hedge against the risk that policy changes lead to higher future tax rates.
- Reduce required minimum distributions (RMDs), giving you more flexibility to manage your tax rates in retirement. RMDs are mandatory annual withdrawals from your traditional retirement accounts that are taxed as income)
- Roth accounts don’t have RMDs, hence they provide more flexibility in retirement income planning, and large Roths can be left to beneficiaries who can then accrue the tax-exempt benefits of Roth accounts for years to come
Q: Does a Roth conversion make sense if I plan to move abroad or already live overseas?
A: An effective Roth conversion strategy must factor in your country of residence’s tax treatment of Roth accounts. Most countries don’t recognize the tax-exempt nature of a Roth withdrawal. In these cases, your Roth contributions will likely be tax-exempt, but withdrawals of your gains will likely be treated as income, which greatly reduces the attractiveness of a Roth conversion.
That said, some countries do recognize the full tax-exempt nature of Roth accounts, usually because of language in their double taxation treaty with the U.S.
Countries that recognize Roth accounts include:
| COUNTRIES THAT RECOGNIZE ROTH ACCOUNTS | ||
|---|---|---|
| Belgium | Canada | Estonia |
| France | Latvia | Lithuania |
| Malta | United Kingdom (UK) | United States (U.S.) |
Additionally, Roth accounts may be a good fit for:
- Low- or no-tax regions (like much of the Caribbean, the Middle East and Eastern Europe)
- Countries that don’t tax foreign-derived income (i.e., territorial taxation nations like Singapore, Hong Kong, Malaysia, Thailand and parts of Latin America)
In those cases, your tax bill will be set by the effective U.S. tax rates, which you’re still responsible for as part of the United States’ citizenship-based taxation.
Q: When is the right time to execute a Roth conversion?
A: Most basically, the right time to do a Roth conversion is when your tax rate is lower than it will be in the future. Some potential reasons for this are:
- You’re moving to a tax jurisdiction that recognizes Roth accounts or won’t tax them as noted above
- You’ve retired but haven’t started taking RMDs or receiving Social Security and other pensions; for many retirees, their RMDs and Social Security force them into a higher tax bracket
- You expect tax rates to rise in the future — even if you aren’t sure what the future holds, a partial Roth conversion can provide an efficient way to protect yourself from rising tax rates
- You’re a net U.S. taxpayer and have earned income below the foreign earned income exclusion (FEIE) and U.S. standard deduction limits
Q: When isn’t the right time to convert to Roth?
A: This is the opposite scenario of the previous question, so you may want to avoid a Roth conversion if:
- You expect your tax rate to fall in retirement. This may be because you’re still working and earning a relatively high income that will drop in retirement.
- You plan to spend your retirement in a high-tax country that doesn’t recognize Roth accounts (like Australia, Germany, Italy or Japan)
Q: What if I make a Roth withdrawal while living in a country that taxes distributions and doesn’t recognize Roth accounts?
A: Expect to be taxed on the earnings/growth of the account. Most countries won’t tax the after-tax basis in the plan (the contributions), but you’ll probably need documentation to show that some of the Roth IRA assets are after-tax contributions. This scenario makes recordkeeping very important.
Q: What can I do to avoid having my Roth taxed if my country of residence doesn’t permit tax-exempt Roth withdrawals?
A: Potential options include:
- Wait until you’re back in the U.S. or a resident of another country that either recognizes Roth accounts or won’t tax them
- Leave the Roth to an heir that lives in the U.S. or another country that either recognizes Roth accounts or won’t tax them as part of your estate planning
Q: Can you give a specific example of how a Roth conversion may save me money?
A: Consider this simplified case: a married American citizen is retiring to the UK with a $500,000 401k that he plans to live off of in retirement. Because of Social Security and pensions, he will already be in the UK’s 40% tax band before he ever takes an IRA distribution. On an after-tax basis, his half million dollar IRA will only be worth $300,000 in the UK — because at least 40%, or $200,000, will go toward UK taxes.
Now let’s say instead of moving with that 401k, he decides to use a Roth conversion strategy during his last two years in the U.S. Because the U.S. has lower tax rates than the UK, he ends up only paying a 22% effective tax rate and is left with a Roth IRA account worth $390,000. That may seem painful, but he’s already $90,000 better off by doing the Roth conversion. And even better, that $390,000 can now grow tax-free. All of it plus any income and capital appreciation can now be withdrawn tax-exempt in retirement. No income tax. No capital gains tax. 1
If you’re a U.S. expat and you think a Roth conversion might benefit you, please contact us to discuss your unique situation. At Creative Planning International, we can help you help determine how you can take advantage of opportunities to lower taxes in retirement as an American abroad.
