Why State Taxes Make Roth Conversions a Huge Opportunity for U.S. Expats
Roth contributions and Roth conversions make sound financial sense for U.S. expats when tax rates in retirement are expected to be as high as, or higher than, they are now. And the exemption from state taxes enjoyed by most Americans living abroad makes Roth conversion an especially attractive financial opportunity. Thus, U.S. expats should capitalize on these investments while they’re still living outside the U.S., as the Roth IRA permits many expats who will return to the United States and retire there to receive large amounts of income exempt from state taxation.
In this article, we’ll dive into how state taxes play a key role in determining whether an expat should conduct a Roth conversion.
Why State Taxes Are an Important Consideration for American Expats
While we know our current tax rate, forecasting future tax rates depends on many difficult-to-forecast variables. For most Americans, the state tax rate makes no difference to the outcome of Roth contribution/conversion calculation, because, in most cases, the change in state tax rates between their working years and retirement years will mirror changes in federal tax rates. This means if you expect your federal tax rate to be lower or higher in retirement than it is during your working years, you can expect the same for state tax rates.
But for Americans living abroad, this assumption doesn’t hold. Most Americans abroad can escape paying state taxes. As a result, when we factor in state taxes across the whole life cycle for Americans currently living abroad, we most frequently find that future tax rates (federal and state) are likely to be higher than current tax rates (federal only), even in cases where federal tax rates in retirement decline along with income.
When future tax rates are as high as, or higher than, current tax rates, Roth conversion is usually the right choice. Therefore, a full elaboration of the Roth conversion calculation that includes an analysis of state tax rates will frequently tip the scales in favor of contributing to and/or converting to a Roth.
Example: How an Expat Family Uses a Roth Conversion to Lower Their Tax Bill in Retirement
To illustrate this concept, let’s examine the hypothetical case of the Jones family, who move from New York to Singapore. They plan to stay in Singapore for five years then return permanently to California. Ms. Jones works as a software engineer and earns approximately $250,000 a year, while Mr. Jones stays home and takes care of the kids for the years they’re abroad.
Jones Family: Federal Tax Rate Considerations
For the Joneses, their combined taxable income (disregarding the foreign earned income tax exclusion) is about $224,000. This puts them in the marginal federal income tax bracket of 33%. They expect to retire when they’re 65, stay in California and live off a combination of investment income (e.g., interest, dividends and capital gains), IRA distributions and Social Security. They estimate their total retirement income will be about $132,000 per year and their federally taxable income will be approximately $113,300. Their retirement federal marginal tax bracket would be 25%.
In this example, basing an analysis only on federal tax rates, it would appear that the Joneses should choose traditional IRA contributions over Roth IRA contributions and that they should not convert their traditional IRA assets at this time, because their current marginal tax rate is a full 8% higher than their estimated retirement marginal tax rate. However, let’s factor in state taxes.
Jones Family: Factoring in State Taxes as Expats
Since the Joneses intend to retire in California, they can expect to pay state income tax at a marginal rate of 9.3% during their retirement years (even though California does not tax Social Security benefits). If they were currently living in California, their California state marginal tax rate would also be 9.3%, and it would not change the analysis — their all-in (state and federal) current marginal tax rate would still be about 8% higher than their projected all-in retirement marginal tax rate, and therefore Roth contributions and Roth conversion would be unwarranted.
However, they don’t live in California. They live in Singapore now and will be subject to California state tax only upon their return to the U.S. Therefore, their all-in current marginal tax rate consists only of their federal rate, while their retirement all-in marginal tax rate will consist of their federal and state tax rates. This analysis yields a current marginal tax rate of 33% (federal) versus 34% in retirement (25% federal plus 9% state).
Thus, including state taxes in the analysis yields a retirement tax rate projected to be 1% greater than current tax rates, versus 8% less when state taxes were ignored. Since the all-in marginal tax rate in retirement is expected to be higher than their current tax rate, Roth contribution and conversion may indeed be a wise strategy for the Jones family.
See a breakdown of traditional IRAs and Roth IRAs in the appendix below.
Other Factors Expats Should Consider with Roth Conversions
The hypothetical Jones family example is a clear case in which living abroad creates a great planning opportunity to take advantage of Roth contributions and even conversion before returning to the U.S. But state taxes can be hard to forecast. Expats should consider these additional factors before conducting a Roth conversion:
Where will you retire?
The biggest issue is considering the tax rate of the state in which you expect to retire.
- If you plan to retire in Florida, or one of the other eight states with no income tax, then state tax analysis will have no impact on the Roth conversion calculation.
- If you expect to retire in one of the states with a relatively low-income tax rate, such as Illinois, the role of state taxes may tip the scale in favor on Roth, or it may not.
- If you expect to retire in a high-tax state such as California, New York or Oregon, there is a high likelihood that the inclusion of state taxes into the Roth calculation will yield a recommendation to employ a Roth (contributions/rollover), if that conclusion was not clear already simply based on an analysis of federal tax rates.
Of course, if you intend to retire abroad, state taxation doesn’t need to be factored into your decision.
Country of Residence Tax Implications
- Americans abroad must also consider local tax implications of Roth conversion. In many jurisdictions, IRA distributions could be taxed at rates that make the conversion unattractive.
Changing Tax Policies
- Tax policies are subject to change, of course. Despite recent tax increases, overall rates of income taxation remain near historical lows. Future tax rates are likely to rise. That fact alone skews the analysis toward Roth conversion now, when rates are still low. This is another strong factor in favor of Roth contribution and conversion now.
Tax Diversification Across Retirement Accounts
- For many younger taxpayers or the merely moderately well-off, making a close to definitive conclusion about whether conversion is financially optimal may not be possible.
There can be too many uncertainties about retirement year financial circumstances to make an accurate estimate of applicable future tax rates. This is one of the reasons taxpayers may want to pursue a strategy of tax diversification.
In this scenario, taxpayers split retirement accounts between Roth and traditional. This approach effectively hedges the taxpayer against the risk of being in a much higher or lower marginal tax bracket during retirement than they anticipated when they made the decision between a traditional or Roth IRA. Tax diversification makes especially good sense for American expats, because the complexity of the conversion calculation is augmented by their special tax and planning circumstances.
Roth Conversions Could Result in a Lower Retirement Tax Bill for Returning U.S. Expats
Making the right decision about Roth conversion requires a high degree of analytical rigor. Many factors must be included in the equation. For Americans abroad, a full accounting of the impact of state taxes is a key variable that in many cases (but not all) will sway the analysis in favor of the Roth option. For more information, read our Q&A on the advantages and disadvantages of expat Roth conversions.
Roth accounts provide an opportunity for American expats to permanently shelter income from state taxes. This benefit alone may result in hundreds of thousands of dollars of extra, after-tax investment income for a typical high-income family.
Ultimately, arriving at the right decision always depends on deep analysis of your unique financial circumstances, including the many factors that apply to Americans living abroad. As always, it’s best to consult with a qualified investment advisor or tax consultant before making a final decision. Creative Planning International can help. Request a meeting with an international wealth manager today to help determine how you can take advantage of opportunities to lower taxes as an expat.
Attributes of Traditional IRAs and Roth IRAs
|Traditional IRA||Roth IRA|
|Tax advantage||Tax-deferred earnings. Current year tax deduction.||Tax-exempt earnings.|
|Eligibility||Investor must have earned income equal to or greater than their contribution.||Investor must have earned income equal to or greater than their contribution. Investor's modified adjusted gross income must fall within the limits prescribed by the IRS.
|Maximum contribution allowed by law||$ 6,000 for 2022 |
($7,000 if age 50 or older).
|$6,000 combined with all other IRAs for 2020 ($7,000 if age 50 or older). The maximum Roth contribution depends on the investor’s income.|
|Tax deductibility||Contributions up to the less of $6,000 ($7,000 if age 50 or older) or 100% of taxable compensation unless the investor (and/or his/her spouse) participates in a qualified employer plan and meets certain income thresholds.||Contributions are nondeductible.|
|Taxes on withdrawals||Ordinary income tax on earnings and deductible contributions. No federal tax on nondeductible contributions. State tax may apply.||Distributions from earnings are federally tax-exempt if over age 59 and a half and the Roth IRA has been owned for at least five years. If under age 59 and a half, distributions are tax-exempt if the investor owned the Roth IRA for at least five years and the distribution is due to death or disability or for a first-time home purchase (with a $10,000 lifetime maximum for the latter). State tax may apply.|