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Choosing Between a Regular and Roth IRA When Living Abroad. What Are the Rules?

Choosing Between a Regular and Roth IRA When Living Abroad. What Are the Rules?

As a US Expat living and working overseas, you have access to a wide variety of international savings and investment plans. If you’re considering adding an IRA account to your portfolio to help secure your retirement, there are a few things you should know about the differences between a traditional IRA and a Roth IRA. Understanding the different rules and taxation methods of each will help you make the best decision for your situation. In this article, we will take a look at some of the benefits of a Roth IRA to many US Expats and review some of the most basic rules and qualifications.

The Difference between a Traditional IRA and a Roth IRA rules

Before we examine in detail why many US Expats prefer a Roth IRA, let’s first take a look at some of the major differences between a traditional IRA and a Roth IRA.

One of the primary differences between the two is the manner in which they are taxed. With a traditional IRA, you get a tax deduction for the contributions you make throughout the year but you will owe taxes in the future when money is withdrawn. With a Roth IRA, you pay current tax rates on your contributions and (as long as all rules are followed) distributions are tax free.

Another difference is the mandatory age to withdraw funds. With a traditional IRA, you must start making withdrawals by age 70½; with a Roth IRA, there is no mandatory distribution age. And yet another difference is in the income requirements. Anybody can open and maintain a traditional IRA – despite his/her level of income. A Roth IRA is reserved for individuals who earn less than $110K per year.

Finally, there are fewer restrictions on early withdrawals with a Roth IRA than with a traditional IRA. If funds have been in your Roth IRA account for at least 5 years, you can generally make a withdrawal without paying additional penalties.

Why Many Expats Prefer a Roth IRA

Short Term and Long Term Tax Savings

There are a few reasons why US Expats prefer a Roth IRA over a traditional IRA, but perhaps none of them are as compelling as the prospect of escaping tax liability altogether. You see, as a US Expat, you most likely qualify for the FEIE (Foreign Earned Income Exclusion) and/or the Foreign Tax Credit. Both of these allow you to claim foreign income or foreign paid taxes to deduct from your US tax liability, and many US Expats find they owe no US taxes at all after claiming these deductions.

There is a catch to this rule, however: In order to deposit your foreign earned income into your Roth IRA, you must have earned more in a fiscal year than you were able to deduct (or chose to deduct) with the FEIE. For example, you may deduct up to $92,900 for the FEIE. If you made $65K, you can choose to deduct only $60K and be subject to US taxation on the remaining $5K in order to be eligible to make Roth IRA contributions. The good news, though, is that you still have other deductions available to you as a US Expat that may help minimize or eradicate your tax liability; so you still end up paying fewer taxes than you otherwise would have with a traditional IRA.

The additional benefit of a Roth IRA as far as tax savings is that you’re removing the possibility of being taxed at high tax rates in the future. Tax rates fluctuate all the time and it’s hard to tell what changes will have taken place by the time you reach retirement age. For all you know, it may skyrocket in the future and return to the high rates of 50% or more that we’ve seen in previous decades. By paying minimal taxes on your contributions to a Roth IRA now as a US Expat, you’re taking steps to make sure that you will never be affected by rising tax rates (at least in this retirement account).

More Financial Flexibility

While the goal of a retirement account is to secure income for your future, sometimes in life there are situations in which you need access to an emergency stash of cash. In a pinch, you would be able to deduct funds from a traditional IRA but not without paying hefty penalties. Once your Roth IRA account has been open 5 years, you can avoid these penalties if you find yourself in a cash emergency and need to make an early withdrawal.

Basic Roth IRA Rules

Maximum Contributions

Generally speaking, you cannot make more contributions to a Roth IRA in a taxable year than is allowed by the IRA Administration. Currently, the maximum annual contribution to a Roth IRA is $5K for ages 49 and below and $6K for ages 50 and above. If you make more contributions than are allowed in a fiscal year, you will be subject to a 6% penalty, but there are two possible ways to avoid this penalty. The first method is to withdraw the extra amount before the due date of your next US expat tax return. The second method is to contact the IRA administrator and request that they allocate the extra balance to the next tax year.

Time Restrictions

In order to get the most benefit out of your Roth IRA, make sure to open it and make your first contribution before April 15.

To get more detailed information about the rules and regulations of having an IRA, make sure to check out IRS Publication 590. If you have any questions about your taxes or the tax implications of either type of IRA that you need answered by an international tax expert, reach out to us at Taxes for Expats.

Ines Zemelman, EA
Founder of TFX