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5 Misconceptions on U.S. Expat Tax Savings Strategies
Author: Joel Baretto, CFP®
July 13, 2023
July 13, 2023
There is frequently considerable ambiguity among American expatriates regarding the intricacies of investing and tax obligations while residing overseas. This confusion can be attributed to the prevalence of misinterpretations and erroneous information pertaining to complex international tax issues. Moreover, tax considerations often vary based on the country of residence, further complicating the development of an effective tax savings strategy for Americans living abroad. To alleviate this confusion, we have outlined five prevalent misconceptions and provided factual insights to facilitate your management of tax strategies as a U.S. taxpayer living abroad.
1. I can easily do a tax-free rollover of my U.S. qualified retirement accounts (i.e., 401k) to a similar retirement plan in my current country of residence.
Facts: The requirements for a qualified retirement plan are set forth in the Internal Revenue Code (IRC) Section 401(a). This section of the code specifies the conditions that a plan must meet in order to qualify for favorable tax treatment, including the tax deferral of contributions and earnings, as well as certain tax deductions for contributions made by employers.
Although a tax-free rollover of a U.S. qualified plan to an IRA or other U.S. qualified plans may be executed while living abroad (under certain conditions), it is highly unlikely that a foreign retirement plan will qualify under IRC Section 401(a), which disqualifies the rollover of a U.S. qualified plan to such foreign plans.
2. Participating in a pension plan in my country of residence provides many of the same tax advantages as a pension or retirement account in the United States.
Facts: Unfortunately, foreign pensions are typically ineligible for preferential tax treatment in the United States. Contributions to foreign pension plans are neither U.S. tax deductible nor tax free or deferred, and in certain situations, you may be taxed on the plan’s growth, even if it remains undistributed.
While some exceptions to these tax obligations exist based on tax treaties with specific countries, it is crucial to have a comprehensive understanding of any potential tax implications before enrolling in a foreign pension plan.
3. Due to FATCA (Foreign Account Tax Compliance Act) regulations, it is virtually impossible to save taxes on my retirement plan strategy while I’m living abroad.
Facts: Although it is true that many well-known U.S. retirement savings plans, such as 401(k) plans, may not be available to most Americans residing overseas, saving for retirement as a U.S. expatriate is still feasible. The essential criterion for participating in a traditional U.S. retirement savings plan is that you must have earned income. The definition of “earned income” may be confusing for most U.S. expats who are utilizing the FEIE (Foreign Earned Income Exclusion) as it takes into consideration the exclusion amount.
Assuming that you have earned income either as an employee or self-employed individual, you may be eligible to save for retirement using an IRA, SEP (Simplified Employee Pension) IRA, Roth IRA, or other tax-advantaged retirement accounts. In case you are self-employed, and your company is a U.S.-based entity, you may be eligible to participate in a solo 401(k) plan.
It is essential to note that several limitations apply, depending on your situation and country of domicile. Therefore, as with most financial matters concerning U.S. taxpayers living abroad, it is imperative to seek advice from a qualified cross-border tax advisor before selecting a suitable retirement savings strategy.
There are also non-traditional tax savings strategies offered through a handful of U.S. based insurance companies that do not have the same risks and limitations (like earned income requirements) as a traditional retirement plan but may provide tax free or deferred growth over time depending on your situation. However, these strategies are highly sophisticated and will require the assistance of a qualified cross-border financial professional.
4. It is possible for me to live and invest like a local in my present country of residence.
Facts: Despite feeling like a local while residing abroad, it is crucial to remember that as an American, financial matters require special attention. In fact, investing like a local in your present country of residence may lead to significant tax liabilities.
One of the most significant errors that U.S. expatriates make is investing in foreign mutual funds or Passive Foreign Investment Companies (PFICs). PFICs are subject to punitive U.S. taxes, and investors are required to file IRS Form 8621, which is time-consuming and entails complex accounting.
Other frequent errors include paying excessive fees for investments that could be obtained in the United States for less, contributing to non-qualified foreign pension plans, and working with a U.S. tax preparer who lacks expertise in navigating the unique challenges of U.S. expatriates.
5. Roth IRAs offer excellent tax advantages for U.S. taxpayers living abroad.
Facts: It is true that Roth IRAs provide significant tax benefits for Americans living in the United States, but these benefits may not always be applicable in other countries. In fact, contributions to a Roth IRA may be subject to double taxation upon withdrawal if proper precautions are not taken. Therefore, it is advisable for U.S. expats to seek the guidance of a qualified international tax advisor before withdrawing from a Roth IRA, to ascertain whether a bilateral tax treaty exists between the United States and their current country of residence.
In conclusion, while it is possible for U.S. taxpayers living abroad to save taxes on their retirement savings plan, the rules may be counterintuitive in the case of U.S. expats due to international regulations. Consult with a qualified cross-border financial professional to help you avoid costly financial planning mistakes.
Disclaimer:
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