CONTRIBUTING TO AN IRA WHILE LIVING ABROAD – HOW U.S. EXPATS CAN AVOID CRITICAL PITFALLS
MANY U.S. EXPATS MAKE TRADITIONAL IRA CONTRIBUTIONS WHILE OVERSEAS
As part of the U.S. Government’s goal to encourage individuals to save for retirement, the Internal Revenue Code allows certain U.S. taxpayers to deduct, from gross income, annual contributions to qualified retirement plans such as traditional Individual Retirement Accounts (IRA). Amounts contributed to IRAs grow tax-free and are only included as ordinary income when withdrawn at retirement age. Many expats continue to take advantage of this tax savings opportunity, and continue contribute to their IRAs even while away from the U.S.
2012 IRA contributions are limited to the lesser of the taxpayers’ earned income or $5,000 (and $6,000 in the case of taxpayers who are 50 or older). Accordingly, it is critical that a taxpayer have at least some earned income in order to be able to contribute to an IRA and enjoy the tax benefit.
The requirement that a taxpayer must have earned income may seem insignificant because, after all, how difficult is to earn $5,500 a year. However, in the case of U.S. expats it can often prove challenging and even counterintuitive to basic U.S. expat tax planning. In fact, in some cases U.S. expats who continue to contribute to their IRAs may not even realize that they will not even enjoy the tax benefit associated with this contribution and may even be exposing themselves to IRS penalties.
THE FOREIGN EARNED INCOME EXCLUSION (FEIE) MAY IMPACT YOUR IRA CONTRIBUTION STRATEGY
As many of you are aware, one of the basic strategies used by U.S. expats to avoid double taxation (in both their country of residence and the U.S.) is to utilize the foreign earned income exclusion (FEIE). This allows U.S. expats to exclude income earned abroad on their U.S. tax return up to a set amount per year provided certain requirements are satisfied (for your 2012 return this amount is set at $95,100). Generally, the key requirement in order to be eligible for the FEIE is for the taxpayer to establish that their “tax home” is abroad. This can be done by either satisfying the physical presence test or the bona fide residence test (please see our overview of U.S. expat taxation for further details regarding these two tests). Although enticing, the FEIE is not always advantageous to U.S. expats. As stated earlier, in order to take advantage of the tax benefits associated with contributions to an IRA (and to avoid penalties associated with excess contributions), you will need to have earned income. Therefore, if you earn $95,100 or less in 2012 and choose to exclude all of your income utilizing the FEIE, you will not be eligible to make any contributions to your IRA.
For example, assume John is a U.S. citizen who contributes annually to his IRA while living in the U.S. At some point, John relocates to the UK due to a promising job opportunity. Once in the UK, without thinking twice, John continues to contribute the maximum amount to his IRA back home in the U.S. However, when preparing his U.S. tax return for his first year overseas, John is advised to take advantage of the FEIE in order to exclude up to $95,100 of his UK based income when calculating his U.S. tax liability for the year. Assuming John’s salary in the UK was $95,000 John was able to exclude his entire salary and can avoid paying any tax in the U.S. Isn’t this great? Not entirely. Since John wiped out his entire earned income by utilizing the FEIE, John is no longer eligible to contribute anything to his IRA. By continuing to contribute, John is now exposed to a 6% penalty on the “excess contributions” (i.e., amounts he contributed to his IRA in excess of his earned income for the year). This penalty is imposed per year as long as the excess amounts are not withdrawn from the IRA.
AS A U.S. EXPAT, THE FEIE IS NOT THE ONLY TAX PLANNING TOOL AT YOUR DISPOSAL
Does this mean that you must start paying double tax on your overseas income in order to benefit from contributions to your IRA? Not at all.
As we have mentioned in the past, the FEIE is a great tool for expat tax planning but it is important to remember that it isn’t the only one. There are other tools, such as the foreign tax credit rules that also provide U.S. expats with relief from double taxation without excluding earned income. Furthermore, although beyond the scope of this article, it should be known that IRA contributions are not always beneficial for U.S. expats, even if done properly. For example, U.S. expats living in low tax jurisdictions (such as Saudi Arabia) may gain no benefit from the deduction available by making contributions to an IRA. Similarly, U.S. expats in the UK may be able to take advantage of certain treaty benefits related to contributions made to UK pension schemes.
Accordingly, it is important to remember that each U.S. expat tax return is different and the tools you choose use for your tax planning should carefully take into account your unique situation.
If you are a U.S. expat and have not yet contributed to your traditional IRA during 2012, it is important that you seek the advice of a qualified expat tax professional that can help you navigate through your unique situation while ensuring that your U.S. tax return is optimized for the most favorable tax results. Remember, it’s not too late! You can still make your 2012 IRA contributions until April 15th 2013 and, more importantly, those of you have contributed excess amounts still have time to rectify this mistake before triggering the penalty on excess contributions.
At Expat Tax Professionals we have the experience and knowledge needed to adequately address these issues and we are more than happy to assist. Visit our website at www.expattaxprofessionals.com for more information.
