The options available in the United States for retirement savings are dizzying and can often seem like an indecipherable alphanumerical soup—like, is there really a difference between 401(k), 403(b), or 457 plans? How about explaining when it makes more sense to utilize a SEP IRA or a SIMPLE IRA?
In today’s article, I will attempt to make some sense of this mess, with one caveat: The majority of retirement planning questions need to be answered by a qualified and licensed financial planner, and are beyond the scope of this article.
My goal for today is to explain the taxation of the various types of US accounts. In fact, if you have sat with a US financial planner, you have probably heard a version of this presentation already (although I would like to think that I can add something to your knowledge).
The “Tax Control Triangle”
Besides for diversifying investments by type and asset class, many financial planners also recommend diversifying your retirement savings by the taxability of the income. In general, financial planners divide income into three classes, and put them into a diagram they call the “tax control triangle”, a term that was popularized by American Express in the 1990s and early 2000s but is now part of the financial advisor vernacular.
The taxation of retirement income is classified by the funding of the account and whether the withdrawals are considered to be taxable. The three categories are:
After-tax dollars, taxed always;
Pre-tax dollars, taxed later; and
After-tax dollars, taxed never.
Let’s go through the categories one at a time.
Category 1: After-tax dollars, taxed always
Category 1 investments include the following:
Bank accounts (checking, savings, CDs)
Brokerage accounts (stocks, bonds, mutual funds)
These investments are your regular savings and investment accounts in which the money is always accessible. Investments are made with after-tax dollars, and the income from the account is taxed every year.
Category 1 accounts have two main advantages. The first is liquidity—in general, you can access money in a bank or brokerage account whenever you need to. The second advantage is that if you hold investments for more than a year, you may qualify for taxation at the lower capital gains rate instead of the ordinary income rate. The disadvantage to these accounts is that because the income is taxed every year, there is not as much money available to grow. That brings us to our next category…
Category 2: Pre-tax dollars, taxed later
Category 2 accounts include the following:
Traditional, SEP, and SIMPLE IRAs
401(k), 403(b), and 457 employer-sponsored accounts
Pensions
Annuities
Category 2 accounts are tax deferred—even though you earn the money during your working years, the income is not taxed until you withdraw the money from the account. The main advantage to using tax-deferred accounts is that you can take advantage of what’s known as “triple compounding”—you earn returns on the principal, the interest, and on the money that would have been lost to taxes if the funds were in a taxable account. In addition, many people (although not all) are in a lower tax bracket in their retirement years than they are during their working years, so they will pay lower taxes than they would have normally.
There are two main disadvantages to tax-deferred accounts, and they are essentially the opposite of what we were talking about regarding taxable accounts. First of all, tax-deferred accounts are generally illiquid before retirement—if you withdraw money from a tax-deferred account before age 59 1/2, you will usually receive a tax penalty in the amount of 10% of the withdrawal. In addition, you cannot take advantage of capital gains rates on IRA and 401(k) withdrawals, as withdrawals are always taxed at ordinary income rates.
Of course, if avoiding taxes is your goal, there is one more option…
Category 3: After-tax dollars, taxed never
Category 3 investments include the following:
Roth IRAs and 401(k) accounts
Municipal bonds
Cash-value life insurance
The advantage to these investments is obvious—who doesn’t like tax-free income? However, these accounts are not appropriate for everyone, and each of them has their particular drawbacks. Roth accounts are subject to similar withdrawal rules as Traditional IRAs. Municipal bonds usually pay lower rates of interest than similar corporate bonds, and the tax savings may not make up for the difference unless you are in a very high tax bracket. In addition, municipal bonds may not be free from the Alternative Minimum Tax. Finally, life insurance can be expensive, and tobacco users or others with preexisting conditions may not be able qualify for it.
Tax-qualified accounts for US expats
US expats can run into a particular issue when it comes to investing in IRAs: In order to invest in an IRA (either a Roth or Traditional IRA), the taxpayer needs to have “earned income” during the year. Therefore, if a US expat uses the Foreign Earned Income Exclusion (Form 2555) to exclude their wage or business income, they may not be allowed to contribute to an IRA.
Finally, for expats, there may be another huge drawback to using tax-qualified accounts: Just because the US considers the gains or income from the accounts to not be taxable, there is no guarantee that other countries have the same policies, and you may find that your ostensibly “tax-free” income is suddenly taxable. The US does have tax treaties with many countries that discuss the taxability of IRAs and Roth accounts, so consult your country’s treaty to make sure that your accounts are being treated as expected by both countries.
As always, speak to your licensed financial planner to explore your options.
Foreign Retirement Income
Besides for any US accounts a US expat may have, you may encounter the foreign equivalents of the above-mentioned concepts in many different forms. We will discuss them in general here, but there are too many variables to cover every scenario—contact us for advice regarding your specific situation.
In general, pensions from foreign sources (including Australian and New Zealand superannuation accounts, Canadian RRSPs and RRIFs, and others) are fully taxable in the US. Exceptions may apply if a tax treaty applies to your situation. If your foreign pension is considered taxable by your country of residence, you can use any foreign taxes paid as a credit against the US tax you would owe on that income by filing Form 1116 (Foreign Tax Credit). Foreign pensions are not considered “earned income”, so they cannot be excluded using Form 2555. Some foreign pensions can also fall under the Windfall Elimination Provision, so be sure to account for that when applying for US Social Security, if applicable.
Reporting Requirements for US Expats
The varieties of foreign savings accounts are dizzying—they can be on any corner of the “tax triangle”, and there are definitely too many types to detail here. However, let’s go through some things that all foreign accounts have in common when it comes to US tax reporting:
All foreign accounts, including bank, investment, and retirement accounts (but not foreign social security), need to be reported on the FBAR (Form 114) and, if the taxpayer qualifies, Form 8938. In the case of Form 8938, make sure to match any taxable income from the foreign account to the corresponding line in Part III of the form.
If you are invoking a tax treaty to change the tax treatment of a source of income, make sure to include Form 8833, as noted in the previous post.
When invoking tax treaties, make sure the treaty actually applies to you. Many provisions in US tax treaties do not apply to US citizens, former citizens, and Green Card holders—check the “savings clause” in the treaty to see which provisions apply in your situation.
When picking investments for your foreign retirement accounts, tread carefully. Foreign mutual funds (or their equivalent) are often classified as “Passive Foreign Investment Companies” (or PFICs) by the IRS, and could be subject to onerous reporting requirements and high taxes. While it is not illegal for a US citizen to own PFICs, the reporting issues are usually enough for most US expats to want to avoid them whenever possible.
Conclusion
Let’s summarize what we have learned about retirement for US expats:
US expats can qualify for US Social Security if they earned 40 credits through covered employment or self-employment.
Social Security is taxed at a variable rate depending on your filing status and income level, ranging from tax-free to 85% taxable.
Foreign social security is usually taxed the same as US Social Security, but check your country’s tax treaty to make sure.
Retirement savings accounts can be taxable, tax deferred, or tax free.
Foreign retirement accounts can have varied and complicated tax treatment in the US, so make sure you are reporting everything correctly and keeping compliant with the ever-evolving standards of disclosure in the US.
In conclusion, expat retirement planning needs to be a part of your long-term financial program, and having an accounting firm that can work together with your financial planner is very important. Contact us for a personalized quote, and we will show you the difference having an expat-centered firm can make.