American Expat Financial Problem: Benefiting from the significant tax advantages of qualified retirement accounts is difficult because of their complexity, especially when the special tax implications of living abroad are factored in.
Understanding how to properly employ tax advantaged retirement accounts is particularly vexing for Americans abroad because they often do not have the easy option of simply enrolling in their company’s 401k plan. Rather, Americans abroad must proactively learn how to employ IRAs, Roths and SEPs, and country of residence retirement accounts to fill the gap.
Over a lifetime of saving and investing, these accounts can provide enormous benefits not only in terms of tax savings, but also in terms of asset protection in litigation situations and estate planning. But investors need to very carefully navigate the complex rules governing these accounts to avoid mistakes that might trigger unnecessary taxation or even the loss of tax deferred status. Furthermore, optimizing the tax advantage of these accounts also requires careful calculation of how stock and bond investments are allocated between taxable and tax-deferred or tax exempt accounts. For the self-employed, proper use of retirement savings accounts is particularly important because of the onerous tax regime imposed by the U.S. on Americans with self-employment income derived from non-U.S. sources. Generally, Americans employed abroad by non-U.S. employers can escape the self-employment tax altogether. But any American living abroad with self-employment (Schedule C) income must pay the full 15.3% tax (unless exempted by a bilateral “totalization agreement”). The burden is compounded by the fact that the U.S. tax rules limit deductions when calculating the amount of non-U.S. sourced self-employment income subject to the tax. However, these disadvantages can be offset by the unique ability of self-employed individuals to shield large amounts of income from the federal income tax through the recent innovation of the “individual 401k.” A simplified version of the cumbersome company 401k, the “individual 401k” offers self-employed entrepreneurs a chance to defer up to $53,000 a year of self-employment income.
Finally, before contributing to any U.S. qualified retirement account, Americans abroad must make sure they understand country of residence tax treatment of such accounts. Bilateral tax treaties between the U.S. and some countries recognize the special tax status of these accounts in the country of residence. But other countries treat U.S. retirement accounts as if it were any normal taxable investment account (see box, p. 8).
Recommendation: Learn how to make full use of tax advantaged retirement accounts
Investors are limited in their ability to affect the performance of stock and bond markets. However, taxpayers have the power to pay more or less in taxes depending on how well they manage the tax impact of our investment strategies. Proper tax management can add as much as 3% of total annual return to a stock portfolio.4 At that rate, an investor can add an additional 100% of total return to your investment account in 24 years, simply by making good strategic tax choices.
Proper employment of tax deferred or tax exempt investment accounts is a critical element of long-term investment success. Americans abroad should take full advantage of these opportunities; the trick is to understand how they work.
Understanding these details requires a lot of homework or the advice of a well-qualified international advisor. Investors should avoid non-U.S. retirement accounts (unless recognized as U.S. qualified by a bilateral tax treaty). These structures have no special tax status as far as the IRS is concerned and often will incur the highly punitive wrath of the PFIC taxation regime. Finally, expats should make sure to understand how country of residence tax law treats U.S. retirement accounts.
Double Taxation and Bilateral Income Tax Treaties – Key Points
- The United States maintains income tax treaties with approximately 70 foreign countries (see Appendix A). These treaties are designed to reduce the incidence of double taxation.
- Tax treaties generally do not reduce the U.S. tax burden of Americans abroad, but may reduce the treaty country’s taxation of Americans living in the treaty country.
- Some (but not all) bilateral tax treaties provide mutual recognition of tax preferences for retirement plan accounts such as IRAs, 401ks company pension plans and their non-U.S. equivalents. They may also provide special provisions for the taxation of public pension plan benefits such as Social Security.
- The U.S. has estate tax treaties with fourteen European countries as well as with Australia, Canada, Japan and South Africa. These treaties are critical in arbitrating the complex interaction of U.S. estate tax rules (applied on the basis of citizenship and residency) and foreign estate and inheritance tax rules. Cross-border families with significant assets need to work with qualified estate lawyers familiar with cross-border estate planning and the role played by these estate tax treaties.
- “Totalization Agreements” are designed to coordinate the benefits of the U.S. Social Security system and the other treaty country’s national pension system. They allow U.S. citizens to get “credit” in the U.S. Social Security system for contributions made to a foreign pension system, or credit in the other country for contributions made to U.S. Social Security.
- Totalization agreements can be especially important for self-employed U.S. taxable persons abroad, because they can reduce or eliminate the need to pay the U.S. 15.3% self-employment tax.
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