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Contributions to Retirement Plans Are Not All Made Equal

Contributions to Retirement Plans Are Not All Made Equal
Ines Zemelman, EA
05 March 2018

Retirement, and how one will fund their retirement, should be at the forefront of most people. We’ll aim to explain the differences between different types of retirement plans below.

This will best be shown with a working example.  Peter, Katie, and Mary all live and work outside the U.S. for one full year. All three receive $100k earned income (ie a job) & $25k of unearned income (investments, rentals, etc). All three utilize the foreign earned income exclusion (FEIE).

The main difference between the three is that they have different sources of income, and contribute to different retirement plans.

US Employer:

Peter receives a salary of $100k from a U.S. employer.  He also receives $25K of unearned income from U.S. investments. Peter makes a contribution of $15K to his employer-provided 401K plan.

Self Employed:

Katie is self-employed. Her net income from self-employment was $100K, of which amount she contributed $15K to a U.S. SEP. Katie receives $25K of unearned income.

Foreign Employer:

Mary receives a salary of $100K from a foreign employer; she does not have a 401K plan. Mary receives $25K of unearned income. She would like to contribute to IRA but it is not allowed. Mary has zero earned income after exclusion while passive (unearned) income does not qualify for IRA.

 

 

Earnings

Earned income post retirement plan contributions

FEIE

Earned Income Remaining

Passive Income

Adjusted gross income

Peter

$100K

$85K

-$85k

$0

$25K

$25K

Katie

$100K

$85K

-$85k

$0

$25K

$25K

Mary

$100K

$100K

-$100k

$0

$25K

$25K

 

Key takeaways:

Contributions to 401K or to SEP reduce the amount of foreign earned income allowed for exclusion; therefore they are treated differently than contributions to Individual Retirement Accounts (IRA).

When Peter and Katie claim the foreign earned income exclusion (FEIE - Form 2555) they exclude earned income, net of their contributions to the retirement plan. 401k or SEP is “deferred compensation” that does not qualify for the exclusion. 

Whereas Mary receives full salary, without a reduction for deferred compensation. Mary excluded her salary entirely. The IRS does not allow double dip that would have occurred if Mary made contribution to a Traditional IRA. Mary also cannot contribute to a ROTH IRA. Zero earned income remaining after exclusion cross out any options for individual retirement contributions.

How can Mary contribute to ROTH or Traditional IRA?

Generally speaking, yes it may be possible for Mary to still contribute to a ROTH or Traditional IRA -- but this calculation requires full analysis of Mary’s tax situation, as blindly reducing less will inevitably lead to generating tax due for Mary, which otherwise would be 0.

Ahead of April 15th, please discuss with your tax preparer your desire to make a retirement contribution. Then, we can work backwards, and compute your tax return, inclusive of the contribution, to determine what is the most you can contribute without raising your tax due.

See related FAQs:

Ines Zemelman, EA
founder of Taxes for Expats