Problem: Benefiting from the significant tax advantages of qualified retirement accounts is difficult because of their complexity, especially when the special tax implications of living abroad are factored in.
Understanding how to properly employ tax advantaged retirement accounts is particularly vexing for Americans abroad as they often do not have the easy option of simply enrolling in their company’s 401k plan. Rather, Americans abroad must proactively learn how to employ IRAs, Roth IRAs, and SEPs, in parallel to retirement accounts in their country of residence to fill the gap. Over a lifetime of saving and investing, these accounts can provide enormous benefits not only in terms of tax savings, but also in terms of asset protection in litigation situations and estate planning.
Investors need to carefully navigate the complex rules governing these accounts in order to avoid mistakes that might trigger unnecessary taxation, or even the loss of tax deferred status. Furthermore, optimizing the tax advantage of these accounts also requires careful calculation of how stock and bond investments are allocated between taxable and tax-deferred or tax-exempt accounts.
For the self-employed, proper use of retirement savings accounts is particularly important because of the onerous tax regime imposed by the U.S. on Americans with self- employment income derived from non-U.S. sources. Generally, Americans employed abroad by non-U.S. employers can escape the self-employment tax altogether. But any American living abroad with self-employment (Schedule C) income must pay the full 15.3% tax (unless exempted by a bilateral “totalization agreement”).
The burden is compounded by the fact that the U.S. tax rules limit deductions when calculating the amount of non-U.S. sourced self-employment income subject to the tax. However, these disadvantages can be offset by the unique ability of self-employed individuals to shield large amounts of income from the federal income tax through the recent innovation of the “individual 401k.” A simplified version of the cumbersome company 401k, the “individual 401k” offers self-employed entrepreneurs a chance to defer up to $61,000 a year of self-employment income.
Finally, before contributing to any U.S. qualified retirement account, Americans abroad must make sure they understand the tax treatment of such accounts in their country of residence. Bilateral tax treaties between the U.S. and some countries recognize the special tax status of these accounts in the country of residence. However, other countries treat U.S. retirement accounts as any normal taxable investment account.
Recommendation: Learn how to make full use of tax advantaged retirement accounts
Investors have zero ability to affect the performance of stock and bond markets. However, taxpayers have the power to pay more or less in taxes depending on how well they manage the tax impact of our investment strategies. Proper tax management can add as much as 3% of total annual return to a stock portfolio. At that rate, an investor can add an additional 100% of total return to your investment account in 24 years, simply by making good strategic tax choices.
Proper employment of tax deferred or tax-exempt investment accounts is a critical element of long-term investment success. Americans abroad should take full advantage of these opportunities; the trick is to understand how they work.
Understanding these details requires a lot of homework or the advice of a well-qualified international advisor. Investors should avoid non-U.S. retirement accounts (unless recognized as U.S. qualified by a bilateral tax treaty).
These structures have no special tax status as far as the IRS is concerned and will often incur the highly punitive wrath of the PFIC taxation regime. Finally, expats should make sure to understand how the tax law of their country of residence treats U.S. retirement accounts.
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