Roth conversions are one of the most effective investment and tax planning tools available to U.S. taxpayers. However, for U.S. citizens 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 conversion and explains when and how the strategy can be used effectively even while living abroad. Please refer to our companion research articles for a background on Individual Retirement Accounts (IRAs) and for 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, 401k, or 403b to after-tax, tax-free income in a Roth 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-free, so you avoid taxation 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 are 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 do not have RMDs, hence they provide more flexibility in retirement income planning and large Roths can be left to heirs who can then accrue the tax-free 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 do not recognize the tax-free 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-free nature of Roth accounts usually because of language in their double taxation treaty with the U.S.
Additionally, Roth accounts may be a good fit for:
- Low or no-tax countries (like much of the Caribbean, the Middle East, Eastern Europe, and even Portugal under their non-habitual resident scheme), or
- Countries that do not tax foreign-derived income (i.e. territorial taxation nations like Singapore, Hong Kong, Malaysia, Thailand, parts of Latin America).
In those cases, your tax bill will be set by the effective U.S. tax rates which you are 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 are moving to a tax jurisdiction that recognizes Roth accounts or will not tax them as noted above.
- You have retired but haven’t started taking RMDs or receiving Social Security and other pensions yet. 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 are a net US tax-payer and have earned income below the foreign earned income exclusion (FEIE) and U.S. standard deduction limits.
Q: When is not 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 current tax-rate to fall in retirement. This may be because you are 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 withdraw while living in a country that taxes distributions and does not recognize Roth accounts?
A: Expect to be taxed on the earnings/growth of the account. Most countries will not tax the after-tax basis in the plan (the contributions), but you will probably need documentation to show that some of the Roth IRA assets are after-tax contributions. This scenario makes record keeping very important.
Q: What can I do to avoid having my Roth taxed if my country of residence does not permit tax-free Roth withdrawals?
A: Potential options include:
- Wait until you are back in the U.S. or resident of another country that either recognizes Roth accounts or will not tax them.
- Leave the Roth to an heir that lives in the U.S. or another country that either recognizes Roth accounts or will not 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 towards 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 free in retirement. No income tax. No capital gains tax. If you think a Roth conversion might benefit you, please contact us to discuss your unique situation.