Expat Financial Planning: Why Americans Should Consider a Solo 401(k)
By Peggy Creveling, CFA and Chad Creveling, CFA
This article is for general information purposes only and is not intended as specific tax advice. Please consult your tax advisor for advice relevant to your situation.
If you're an American working overseas who's a contractor, sole proprietor, or small business owner, you may think that there are few U.S. tax-advantaged choices available to help you save for retirement. Those expats not working for U.S. firms are often unaware that they could be eligible to contribute to U.S. tax-advantaged retirement plans. Depending on your situation, however, there may be several alternatives from which to choose. The solo 401(k)―sometimes referred to as the single 401(k) or individual 401(k)―is one that can be a powerful retirement savings tool for some U.S. expats who are self-employed or who own a small business.
Benefits of Solo 401(k) Plans
Qualified expat contractors, sole proprietors, or small business owners can gain from contributing to a solo 401(k) plan in several ways. Of course, there are obvious benefits to accumulating savings in U.S. tax-advantaged accounts. But with the solo 401(k), you can contribute much more on an annual basis than you can to individual retirement accounts (IRAs), and even than to other small business plans such as the simplified employee pension IRA (SEP IRA). Finally, with a solo 401(k), you also have the option of making either tax-deferred or tax-exempt (Roth) contributions.
Solo 401(k) Eligibility
Your sole proprietorship or small company can establish a solo 401(k) plan, provided that the only eligible plan participants are you the business owner and your U.S. spouse (if you have one). Generally this means you won't be able to set up a solo 401(k) if you have other U.S. employees. It's worth noting, however, that depending on your specific 401(k) plan documents, certain types of employees may be ineligible to participate, including nonresident aliens, part-time employees, and those younger than age 21. If your only other employees fall into one of these categories, a solo 401(k) plan may still be an option for you.
Contributing to a Solo 401(k) Plan
Similar to other 401(k) plans, solo 401(k) plans can allow contributions in the following ways:
- An employee contribution of up to $18,000 (2016) if younger than age 50, or $24,000 if age 50 or above
- An employer (or profit-sharing) contribution of:
- Up to 25% of net adjusted business profits for those not required to pay self-employment tax
- Up to 20% of net adjusted business profits for those who are required to pay self-employment tax
For expat solo proprietors, contractors, or owners of foreign small businesses, a portion of your salary is effectively designated as the profit-sharing contribution. The maximum annual total limit for all types of contributions is $53,000 (2016), or $59,000 if age 50 or over.
U.S. Tax Implications
Pretax option: Qualified contributions (employee and profit sharing) can be deducted from U.S. taxable earned income at the time of contribution. These contributions then grow on a tax-deferred basis until you begin to withdraw them after age 59½, at which time they will be taxed as ordinary income at your future U.S. marginal tax rate.
Roth option: If your 401(k) plan documents allow it, the employee contribution portion can also be made to a Roth vehicle, and contributed to a separate Roth 401(k) account that will grow free of U.S. tax.
After-tax option: If the plan allows it, you may be able to make voluntary non-Roth, after-tax contributions of up to $53,000 (2016) or $59,000 if age 50 and roll these non-Roth, after-tax assets to a Roth IRA without conversion or tax implications.
Whether it's better for you to make pretax, Roth, after-tax, or combination contributions to a 401(k) plan will depend on your individual situation. You'll want to run through your potential U.S. tax burden now and as projected into retirement in order to make the best choice.
Special Consideration for Expats: The IRS Says Unexcluded Earned Income Only
While qualified U.S. expatriates can establish and contribute to solo 401(k) plans, you should be aware that contributions can only be made on unexcluded earned income (such as wages or self-employment income).
We emailed the IRS at RetirementPlanQuestions@irs.gov to ask whether 401(k) contributions could be made if a taxpayer's earned income was excluded using the foreign earned income exclusion (FEIE). An Employee Plans specialist at the IRS answered: "No. As per IRC 1402(a)(11), IRC 3401(a)(8), IRC 911 and Revenue Ruling 70-491." Note that Revenue Ruling 70-491 states that income excluded under the FEIE cannot be contributed to employment retirement plans that are formed under Internal Revenue Code 401.
Unfortunately the IRS's response seems clear: If you have no earned income or if you've excluded all earned income from U.S. tax using the FEIE and the foreign housing exclusion (FHE), you cannot contribute to a solo 401(k).
However, if you're currently excluding all of your earned income using the FEIE, in some cases it could make sense to revoke using the FEIE in order to contribute to a solo 401(k) plan. For example, if you pay a lot of local tax on your salary in the country you live, you may find that switching to using the foreign tax credit won't leave you worse off in terms of U.S. tax. Bear in mind, however, that if you make this switch and then change your mind within five years, you'll need to apply for IRS approval to resume using the FEIE by requesting a ruling from the IRS.
Summary
Solo 401(k)s can be a great way for U.S. expat contractors, sole proprietors, and some small business owners to save a significant amount each year in U.S. tax-advantaged accounts. You'll want to check with your U.S. tax advisor on whether establishing and contributing to a solo 401(k) or solo Roth 401(k) plan makes sense for you.
Additional Resources
IRS Publication 560, "Retirement Plans for Small Businesses"
IRS Publication 4222, "401(k) Plans for Small Businesses"
One-Participant 401(k) Plans
This article is a revised and updated version of one that appeared previously on www.crevelingandcreveling.com .