WSJ Ask An Expert: Six Mistakes Expats Make With IRAs—And How to Avoid Them

The Wall Street Journal invited Creveling & Creveling to be part of a panel of experts for personal finance on its WSJ Expat site. The following article originally appeared on the WSJ site and has been shared with permission:

Individual retirement accounts can be a great tool for those saving for retirement.  The combination of tax-deductible contributions and tax deferral often allows funds to compound faster than in a taxable account.

But the problem for expats is that the IRA rules were written for the U.S. tax code, which can often conflict with the tax codes of the countries where they live and work. While a number of countries maintain double-taxation treaties with the U.S., so that expats don’t have to pay taxes in both countries, very few countries outside the U.S. allow expats to defer local taxes on their U.S. IRAs.  IRA mistakes can be costly for U.S. expats.

Despite the potential complexity, IRAs can still be a great savings tool for expats; you just need to know the rules. Here are some examples of the most common problems we encounter working with expats:

Making contributions with no un-excluded earned income.

Joe teaches in an international school in Singapore.  His annual salary and bonus total $100,000 in U.S. dollars, and he receives a housing allowance of $30,000.  For U.S. tax purposes, he excludes his salary and housing allowance using the foreign earned income exclusion (FEIE) and housing deduction.  Additionally, with his after-tax earnings, he makes an annual contribution to a Roth IRA ($5,500 in 2016 for those under 50; $6,500 for those over 50).

Joe’s mistake: To make a contribution to any type of IRA (traditional or Roth) you must have un-excluded earned income. This means that if you use the FEIE and housing deduction, to make IRA contributions, you must have earned income above the amounts you exclude. If you don’t and you have no other U.S.-sourced earned income, you cannot make a contribution to an IRA.

We often see expats who file their own taxes make this mistake and the penalty can be steep. Excess IRA contributions are taxed at 6% annually for as long as the excess contributions remain in the IRA.

Contributing for an NRA spouse while filing as head of household.

Jim and Wannada, his non-U.S. wife, live in Thailand with their two children.  Jim earns $200,000 per year and files his taxes as head of household. He makes deductible IRA contributions to his IRA, as well as an IRA that Wannada has opened.

Jim and Wannada’s mistake:  Many expats file their taxes as head of household (if they have children) to keep a non-resident alien (NRA) spouse out of the U.S. tax system. Although this is often the best way to file for many expats, making an IRA contribution for an NRA spouse is not allowed.

In a case like this, it might make sense to file “married filing jointly” with a non-U.S. spouse, especially if the spouse has little income or assets outside the U.S. (American Expats with Foreign Spouses: Choosing Your US Tax Filing Status). In other words, if the U.S. spouse files this way instead of as “head of household”—and assuming there is enough un-excluded income—then the U.S. spouse could contribute to the spouse’s IRA.

Failing to realize that there are income limits on Roth contributions.

Mary is a senior executive at a multinational French bank. As an expat employee, she receives a number of valuable benefits, including salary, bonus, housing allowance, share options and a case of wine each year. Her total annual compensation is above $350,000. Because she is tax-equalized, her employer hires an accounting firm to handle her U.S. taxes. She makes her own separate Roth IRA contributions with after-tax earnings. Since she earns well above the FEIE and housing allowance, she figures this should not be an issue.

Mary’s mistake: She doesn’t realize that there are upper income limits on Roth IRA contributions. Many high-income expats who have sufficient un-excluded earned income make contributions to Roth IRAs without realizing this.

The income we are talking about here is your Modified Adjusted Gross Income (MAGI). The 2016 upper MAGI limits for Roth contributions are:

For single filers and those filing as head of household, the amount you can contribute to a Roth begins to diminish and eventually phases out if MAGI is between $117,000 and $132,000. Above $132,000 no contributions to a Roth are allowed.

For those filing “married filing jointly,” the phase out is between $184,000 and $194,000 with no contributions allowed above $194,000.

As with the previous examples, the penalties for excess IRA contributions apply here as well.

Not realizing income limits don’t apply for IRAs (not Roths) if you are not contributing to a qualified retirement plan.

When she learns about the Roth IRA contribution limits, Mary decides she cannot contribute to an IRA at all.

That’s her second mistake: Income limits for traditional IRAs do not apply if she is not contributing to a U.S. tax-qualified retirement plan. This opens the door for many high-earning expats to make IRA contributions.

For example, if Mary was working for a U.S. multinational and making contributions to a 401(k) plan through her work, the traditional IRA income limits would apply and she would not be able to make a deductible IRA contribution. However, as she is working for a foreign company and has no U.S.-qualified retirement plan, the income limits do not apply. As long as Mary has un-excluded earned income, she can make a deductible IRA contribution.

Also, expats with un-excluded income can always make a non-deductible contribution to a traditional IRA. You won’t get the tax deduction on the contribution, but you will get tax-deferral on earnings. This may also be combined with a “backdoor Roth”—a technique for those who earn too much to get savings into a Roth IRA—or roll over to a Roth. This loophole in the U.S. tax code means that you cannot just roll your non-deductible contribution to a Roth; it must be rolled proportionally with your aggregate IRA balances. For those with no or little traditional IRA amounts, this procedure can make sense. For those with large traditional IRA balances, the “backdoor Roth” might end in a higher tax bill and not be worthwhile.

The 2016 income limits (MAGI) for deductible IRA contributions for expats with qualified US retirement plans are:

For single filers and those filing as head of household, the deductible amount you can contribute to a traditional IRA phases out between $61,000 and $71,000. Above $71,000 no deductible contributions to an IRA are allowed.

For those filing “married filing jointly,” the phase out is between $98,000 and $118,000 with no deductible contributions allowed above $118,000.

Not considering double taxation when making deductible IRA contributions.

Bill lives and works overseas and is subject to tax both in his country of residence and in the U.S. He uses the foreign earned income exclusion, housing deduction and foreign tax credits to lower his U.S. tax bill. Since he earns $375,000, he also makes a deductible IRA contribution of $5,500. This saves him $1,000 (18%) on his U.S. tax bill, and nothing in his country of residence.

Bill’s IRA mistake is one of the most common that expats make. His income has already been taxed by his country of residence. To avoid double taxation, the U.S. allows the foreign earned income exclusion of up to $101,300 for 2016 and foreign tax credits for amounts above this.  Bill has effectively taken after-tax income and, by making a deductible contribution to an IRA, made it pre-U.S. tax.

By doing this, Bill has just set himself up to be taxed twice on the same income. The amount designated as a deductible contribution is not taxed by the U.S., but it was already taxed by the foreign country.  The contribution will then be taxed again by the U.S. upon distribution from the IRA. Although Bill did lower his U.S. tax bill by 18% of the contribution, all of the amount in the IRA (contributions and future earnings) will be taxable at his future marginal rate. His future marginal rate is almost certainly going to be higher than 18%—especially if he retires in a U.S. state with its own income tax.

If you are living and working in a foreign country with a high tax regime compared to the U.S. rate, generally it will not make sense for you to make a deductible IRA contribution. If you are working in a country with lower taxes than the U.S., there may still be some benefit, but you will need to look at your U.S. taxes both with and without the deductible contribution to determine how much benefit you will receive.

Failing to take required minimum distributions on inherited IRAs.

Karen has inherited a small IRA from her father. As an expat, she is busy working and traveling and doesn’t have a lot of spare time to devote to her finances. Retirement and the U.S. seem far away. Sometimes she forgets about the inherited IRA and doesn’t take required minimum distributions according to schedule.

This mistake is not limited to expats, but is something we are seeing more of among middle-aged and older expats who inherit IRAs from their parents. According to the IRS, the beneficiary of a non-spouse-inherited IRA must begin making annual required minimum distributions by Dec. 31 of the year following the death of the IRA account holder (the rules are different for IRAs inherited from a spouse).

This requirement applies to both inherited traditional IRAs and Roth IRAs. There is a specific formula that must be followed each year for calculating the required minimum distribution. Unfortunately, many brokers or custodians where the account is held will not do this calculation or distribution for you.

The penalty for failing to make the distribution is steep, amounting to 50% of the amount that should have been withdrawn.

Overall, IRAs can be great savings tools for expats, but you must follow the rules and consider whether contributions make sense for your situation.