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Guide to Investing and Financial Planning for Americans Living Abroad

How to Stay on Top of Your Finances While Living Abroad

Many Americans find that years spent abroad turn out to be the most financially rewarding of their lives. However, while careers advance and bank accounts grow, expats are often too busy to develop a winning long-term investment plan. The predicament is compounded by the complex tax, logistical, and strategic planning considerations faced by Americans living outside the United States.

The good news is that these issues can be successfully managed and need not impede the implementation of a sound long-term wealth accumulation plan. While recognizing that each individual situation is unique and requires its own set of solutions, this report identifies key issues that confront almost all expatriate Americans when it comes to investing and managing their finances.

Where to Bank and Invest

Problem: Should Americans abroad keep their cash and investments in the U.S., country of residence, or offshore?

Americans abroad often end up investing through financial institutions in their place of residence or in popular financial centers such as London, Amsterdam, or Hong Kong. This is especially true when living abroad becomes a permanent or semi-permanent situation. However, when a full accounting is made of all factors that need to be considered, investing through non-U.S. financial institutions is almost always a costly mistake for Americans. Why?

  1. Fees: Whether one chooses to go with a large reputable investment bank headquartered in Switzerland or venture into the world of off-shore banking, a large part of an investor’s potential gain will be consumed by the very high fees charged by non-U.S. financial institutions. These fees are high everywhere in the world, but they are still much lower in the U.S. than anywhere else. A recent study in the Review of Financial Studies of mutual fund fees by country found that among 18 developed European, American and Asian markets, fees in the U.S. were by far the lowest. For example, average expenses for mutual funds sold in Switzerland, the UK and Canada were 43%, 50% and 279% higher, respectively, than in the U.S. The numbers are especially striking for money market funds, where returns are very low to begin with: Swiss money market fund expenses average 1.14% while in the U.S. the average was 45% less.1 If an investor goes further afield into the world of offshore investing (in places such as Lichtenstein, Cyprus and the Cayman Islands) fees, commissions and transaction costs will be even higher than already costly European investments.
  2. Investment access and liquidity: U.S. financial markets provide greater global investment access and liquidity than any other market in the world. There is virtually no investment anywhere in the world that cannot be bought easily and inexpensively on U.S. markets. For example, almost every publicly traded company in the world lists its shares for trade on U.S. exchanges as well as in their home country. The vast and competitive U.S. fund industry makes virtually every global asset class open to efficient and low-cost investment through U.S. accounts. Liquidity for investments such as ETFs (Exchange Traded Funds), global stocks, bonds and commodities is higher in the U.S. than other global financial centers. High liquidity reduces transaction costs and raises long-term rates of return on investments.
  3. Taxes: Taxes are the next big reason that Americans should stay away from non-U.S. registered investments. Long-term investors in U.S. securities benefit from a low capital gains tax rate (15-20%). Additionally, taxes are paid on a deferred basis (only when the investment is sold). For U.S. taxable investors, neither of these significant tax advantages apply to investments in mutual funds, hedge funds or other kinds of pooled investments not incorporated in the U.S. Rather, such non-U.S. securities are classified by the IRS as Passive Foreign Investment Companies (PFIC) and are subject to a special, highly punitive tax regime. PFIC rules can easily push tax rates on investment income to as high as 60-70%. Furthermore, the new FATCA legislation dramatically increases the ability of the IRS to enforce compliance with these rules and ratchets up penalties for non-compliance.
  4. Reporting: The complexity of the U.S. tax code makes year-end accounting statements provided by U.S. brokerages invaluable. U.S. brokerage firms like Schwab and Fidelity supply their clients with detailed activity reports in the required IRS format segregating dividends, qualified dividends, taxable and non-taxable interest income, and short and long-term capital gains, to name only the most important categories, each of which requires distinct tax treatment. Non-U.S. institutions generally do not provide this kind of detailed reporting.
  5. Compliance: If cumulative assets held by an American citizen at financial institutions outside the U.S. at any time exceed $10,000 they must be reported to the U.S. Treasury for that year. Moreover, as a consequence of FATCA, financial assets exceeding $50,000 held
  6. at non-U.S. financial institutions ($300,000 for U.S. taxable person not resident in the U.S.) must now appear on U.S. tax returns. Both the taxpayer and the non-U.S. financial institution must report on assets held by U.S. citizens. Filing the required documentation may increase the likelihood of an IRS audit. Penalties for not filing are severe and IRS resources being directed at enforcement have increased significantly in recent years.
  7. Safety: Regulatory standards in global banking centers range from very high (Switzerland) to almost nonexistent in some of the more exotic offshore banking locales. FDIC deposit and SIPC investment insurance automatically cover all U.S. accounts, but are unavailable for non-U.S. accounts.

Recommendation: Keep investment accounts in the U.S. and bank accounts in your country of residence

For the reasons discussed above, we advise American citizens to maintain investment accounts in the U.S. In addition, Americans abroad should open local bank accounts in their country of residence. Local income and living expenses should be managed through this local account to avoid the expense of constantly converting between currencies. Money allotted for savings and investment, however, should be moved to the U.S. account and invested.

Currency Management and Global Investing

Problem: How can Americans abroad best manage the impact of big currency swings, and diversify their investments globally?

While Americans have to be aware of the many pitfalls that come along with taking their money out of U.S. institutions, it does not prevent holding a portfolio of international assets. On the contrary, Americans abroad who expect to remain outside the U.S. for an extended or indefinite period of time need to manage their long-term currency risk by matching the currency denomination of their investments with the currency in which they expect to incur the bulk of their future expenses (such as home mortgage payments, college costs, and retirement expenditures). For example, an American who is a long-term resident of France, who expects to raise and educate children, and possibly retire there, should have a large share of their investments in European stocks and bonds. Matching the currency of likely future expenses to assets in this manner limits the risk that large currency swings will impede long-term planning objectives. For Americans who expect to return to the U.S. after only a few years abroad, a more dollar focused investment strategy is warranted: U.S. stocks and bonds should constitute the largest part of the portfolio and smaller allocations should be made to international securities to maintain diversification.

Recommendation: Invest in a diversified, multi-currency portfolio of global assets.
We recommend that Americans abroad pay particular attention to the importance of maintaining global diversification and avoid a common bias towards U.S. investments. Many expatriate Americans are not sure where their careers and lifestyles will take them. For these investors, a very broadly diversified multi-currency portfolio makes the most sense. For Americans planning long-term residence in Europe, a portfolio with a large component of European stocks and bonds makes the most sense. Buying foreign stocks and bonds does not require working with a foreign broker. A diversified portfolio of European stocks, for example, can usually be bought more cheaply through a discount U.S. broker than through a European broker.

Passive Foreign Investment Companies: What Americans Abroad Need to Know

Passive Foreign Investment Company (PFIC) rules are one of the least understood aspects of the U.S. tax code that impacts cross-border investors. These rules are designed to discourage Americans from moving money outside of the United States to avoid taxes. Any non-U.S. incorporated investment fund that derives 75% of its income from passive activities is by definition a PFIC. This includes virtually all hedge funds and mutual funds incorporated outside the United States. The details of the PFIC rules are complex but boil down to a default taxation formula whereby all capital gains are taxed at the highest current marginal tax rate (currently 37%). Unlike U.S. funds, there is no favorable long-term capital gains treatment. To make matters worse, the IRS assumes that all gains were made ratably over the entire holding period, and then assesses interest on the gains that were deferred during the holding period. This formula often results in total taxation rates above 50%. Owners of PFICs can elect an alternative taxation method called “mark-to-market,” but only if the election is made in the initial year of reporting the asset. This method requires taxes to be paid annually on increases in market value at the highest marginal tax rate (currently 37%). Unlike mutual funds, then, there is no tax deferral until sale and no lower capital gains rate. Additionally, losses cannot be used to offset other capital gains. Finally, these expenses don’t include the significant costs for tax preparation.

Ultimately, PFIC taxation is so punitive that non-U.S. investment funds are unlikely to provide returns that compensate for these negative tax consequences. Nevertheless, many tax preparers are either unfamiliar with the rules or simply unaware of the registration of their clients’ investments. Previously, this rarely created a problem because the IRS didn’t have the tools to enforce the PFIC rules. However, FATCA legislation (designed to stop U.S. taxable persons from using non-U.S. accounts to avoid taxes.) imposes new reporting rules on all non-U.S. financial institutions, requiring those institutions to provide detailed reporting on accounts owned by Americans. Thus, the IRS can determine easily whether investments in those accounts are PFICs.

This is an overview of PFICs. For a detailed report please see our Research Report on PFICs.

Portfolio Management

What special considerations apply to building an investment portfolio while living abroad?

Fundamental principles of portfolio management apply equally no matter where in the world the investor lives; however, asset allocation changes. Local currency and economic conditions need to be factored into the investment portfolio to get the right mix of exposures. Currency and global diversification being the most salient factors. To be successful in the long run, investors need to focus on four issues when making investment choices:

  1. Currency and geographic diversification:Currency management strategy is a complement to, but not a substitute for, proper investment portfolio diversification. All investors, wherever they live, need to invest in a broad array of assets, including U.S. stocks, international stocks, bonds, emerging markets, and real estate. Proper diversification can substantially mitigate losses incurred during a severe market downturn. This, in turn, helps sustain portfolio stability, and reduces the risk that the investor will sell out near a market bottom as a result of either need or emotion. Decades of academic research and real world investor outcomes confirm that diversification is the only way to maximize returns for a given level of risk.
  2. Risk: Within a broadly diversified portfolio, the relative weight of higher return/higher risk investments (stocks) versus lower risk/lower return investments (bonds) needs to match the risk profile of the investor. Generally, as retirement approaches, investors should reduce exposure to a large market downturn by steadily increasing the weight of bonds in their portfolio. Many other factors — job security, near-term spending plans, or expected college expenses for example — also impact this calculation. Factoring in the right amount of risk is critical to providing the returns necessary to meet planning goals without being overwhelmed by the impact of market volatility.
  3. Expenses: The ability of professional stock pickers and strategists to beat the market has repeatedly been shown to be exceedingly rare. A study of the performance of all U.S. Large Company mutual funds over 20 years found that the average fund underperformed the S&P 500 stock index by 2.6% per annum.2 A European study looking at the period 1975-2006 found that a mere 0.6% of all fund managers succeeded in consistently picking more winners than losers.3 The biggest reason for this dismal record lies in the high fees charged by fund management companies and brokerage firms. With long-run, annual stock market returns averaging around 9%, sacrificing 2.6% of an investment to annual fees and expenses will reduce the total return on an investment by 39% over 20 years. Over 40 years the investment return will be reduced by 62%. Therefore, investors must pay close attention to the cost of investing their money.
  4. Tax Management: A less obvious but still very serious impediment to long-term investment success is poor investment tax management. Portfolios with high turnover not only incur high commission and trading expenses, but also trigger taxation of capital gains earlier and at higher rates. A stable, low turnover portfolio that defers taxation and benefits from the low long-term capital gains rate will generate dramatically better after-tax returns than a fund that performs equally well on a pre-tax basis, but which has high turnover.

RECOMMENDATION: Use modern investment tools such as exchange traded funds to build a stable, diversified portfolio with the right amount of risk; manage investments to maximize returns on an after-tax, after-fee basis.

These recommendations are especially relevant to Americans abroad because of the unfortunate tendency of many expats to change investment strategies as frequently as they change countries and to pay unnecessarily high investment fees (which are often hidden in complex derivative structures and non-transparent investment funds). These mistakes are easily avoidable. Modern investment instruments such as index mutual funds and exchange traded funds give investors all the tools needed to build a globally diversified portfolio of assets. No matter where they live, American investors working on their own or with the assistance of an advisor can (with some exceptions) open an account at one of the large U.S. discount brokerage firms and successfully employ these principles to build a winning long-term investment portfolio.

 

Retirement Planning for Americans Abroad

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 401(k) 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 401(k). A simplified version of the cumbersome company 401(k), the individual 401(k) 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.4 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.

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.

 

Cross-Border Families

PROBLEM: Many Americans who live abroad end up marrying non-Americans. From an investment and financial planning point of view, this can create opportunities as well as dilemmas.

 

RECOMMENDATION: Use the tax code to keep as much money as legally possible away from U.S. taxation.

The planning strategy should be to keep as much income as possible out of the taxation jurisdiction of the IRS. There are a variety of ways to do this in mixed marriages. For example, if the non-U.S. spouse is earning significant income, then married filing separately is likely the appropriate election when it comes to U.S. taxes. Even though this election limits deductions and credits, it prevents the IRS from taxing the non-citizen spouse’s income.

Married couples also need to plan carefully around estate and gift tax issues. At death, there is no limit to the size of the estate that can be transferred tax free to a surviving U.S. citizen spouse. However, if the spouse is not a U.S. citizen, estate taxes will be immediately imposed at a rate of 40% on the entire taxable estate amount.

The estate tax exemption amount is $12 million (2022). This means that only the assets exceeding this amount will be subject to the estate tax. However, for a wealthy U.S. citizen with a non-resident alien spouse, it is important to recognize that this exemption amount applies to assets left to the non-resident alien spouse without benefit of the unlimited exemption amount that prevails when both spouses are U.S. citizens. In certain circumstances, trusts can also be used to address this problem.

Spouses can also transfer up to $164,000 a year (2022) to their non-citizen spouse gift tax free. This provision can provide a very useful planning device for Americans with spouses who have residence in a country with lower tax rates. By making an annual spousal gift, the money can be permanently removed from the tax purview of the U.S. government, both in terms of capital gains, dividend income taxes, and estate taxes.

The U.S. tax code provides a plethora of tax advantaged ways to save for your children’s education. Coverdell accounts and 529s are usually the best options. Americans abroad are often surprised to find that many universities outside the United States are qualified institutions: this means that tax-free distributions from these accounts can be used to pay tuition and expenses at these non-U.S. schools. Furthermore, because of the large amounts of money that can be sheltered from taxation through 529s, these accounts have great value as long-term estate planning tools in the right circumstances.

 

How to Choose an Advisor

PROBLEM: Brokers and advisors outside the United States do not understand how U.S. taxation works, and most brokers and advisors in the U.S. do not understand the special issues of Americans abroad. How can I choose a proper advisor?

 RECOMMENDATION: Seek out the advice of a “fee-based” Registered Investment Advisor with experience working with expats.

 Fee-based advisors are compensated only by their clients. By not taking commissions on advisory products, the potential for conflict of interest between the client and advisor is reduced.Why Registered Investment Advisors (RIAs)? RIAs are legally bound to act as fiduciaries to their clients at all times and in all aspects of the relationship. That is, they have a legal obligation to put the clients’ interests ahead of their own. Brokers are not RIAs and have a fiduciary obligation only when recommending a product to their clients.

What to avoid? Avoid relying on investment advice from advisors such as stockbrokers or insurance agents, who are compensated by selling products through commissions and fee sharing agreements with the issuers. In these situations, the advisor has an incentive to recommend investments based on the size of their potential compensation rather than the quality of the investment and strategy. Additionally, investors should be especially careful when considering investments registered in off-shore locations. There is a high incidence of fraud among these operations. Even legitimate investment schemes in these regions typically lack investor safeguards that exist in the U.S. Finally, understand the tax rules regarding investments outside the U.S.

 

 

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President & CEO, Creative Planning

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