Many expat entrepreneurs are interested in the financially independent, retire early (FIRE) movement. The tips below can help FIRE for US expats become a reality.
FIRE for US Expats Can Become a Reality
We’ll begin with some strategies that you should consider if your situation allows.
Consider a “Tax-Free” Roth IRA Conversion.
In the past few years, Roth IRAs have been gaining in popularity, primarily because of the incredible power that compound interest and regular investment contributions have in building a tax-free retirement nest egg. If you have an existing 401(k) or traditional IRA and would like to convert it to a Roth IRA variant, you can – but you’ll pay taxes on the income as it rolls over.
For expats, there’s a “tax-free” variant for you to use—a hack, if you will. For 2019, there is a foreign earned income exclusion (or FEIE) of $105,900 per employed expatriate. Essentially, you can earn up to that limit without paying US federal income tax. If single, you also have a standard deduction of $12,000 ($18,000 if head of household and $24,000 if married filing jointly) as well. So, single expats can earn up to $117,900 (the FEIE and standard deduction) and not pay federal income tax, no matter the source—including IRA conversions. See where this is headed?
If you’re an expat working abroad, and your salary is $105,900, for example, that income is all excluded, but you also have $12,000 in additional money that can be earned and is subject to—but doesn’t generate—tax. In this scenario, an expat could convert up to $12,000 of a traditional IRA or 401(k) balance to a Roth and owe no taxes on the conversion. So, you’ve made a tax-free conversion, and no tax will ever be paid on that money! That’s step one toward FIRE for US expats.
Utilize Tax-Gain Harvesting to Achieve Tax-Free Savings.
You may have heard of tax-loss harvesting in the past, which is a strategy of selling some investments at a loss in order to offset more substantial gains by another sale of assets. This has been popular for a long time and has its place. Well, tax-gain harvesting is simply the inverse of that strategy. You sell investments at a gain to generate capital gains and either keep the gains or reinvest the money in a similar investment.
The rationale for this strategy is that your capital gains rate is tied to your level of earned income. For 2019, it is structured as follows:
|Long-Term Capital Gains Tax Rate||Single Filers (taxable income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|20%||Over $434,550||Over $488,850||Over $461,700||Over $244,425|
Assuming your income is in the 0% tax bracket, harvesting those gains now will offset any capital gains tax and allow you to reinvest the greater amount while creating a larger basis at the same time—without tax consequences. This can be done if you’re in a higher income bracket. You might pay 15% this year, but if you wait until next year and you know your income will be higher, that pushes your rate higher to the 20% rate. Or, you could be wary of the government changing rates (which is not uncommon) and want to get out ahead of that change. This is a powerful savings tool. However, for expats, even more significant savings are possible.
In the previous example, we discussed the FEIE that allows you to exclude $105,900 from taxable income federally in 2019. Take an example of a single expat earning a salary of $100,000 abroad and excluding it all under the FEIE. While abroad, the expat has a possible capital gain of $20,000 on an appreciated asset. If they go to sell and their earned income is $0 thanks to the exclusion, they can harvest the capital gain of $20,000 completely tax-free and reinvest it all to achieve huge savings. Keep in mind that once your income exceeds the FEIE limit, taxes are assessed.
Pay Nearly Zero Tax as a Self-Employed Expat.
There’s a misconception that self-employed expats living abroad aren’t eligible to take the FEIE. This simply isn’t true. In fact, it is an incredibly powerful strategy to minimize almost all income tax, depending on your situation, and can help boost your chances of achieving FIRE for US expats.
Consider this scenario: Jane D. Expat is self-employed and runs a successful consulting business. She is eligible for the FEIE. Her husband, Tom D. Expat, has moved abroad with her. Jane can hire her husband to work in the business. Now, each of them has a possible $105,900 exclusion (a total of $211,800). In addition to this, there is the standard deduction for filing jointly ($24,000). They’re now at $235,800 income tax-free. Assume there is a company 401(k) plan as well, and each of them contributed the maximum of $19,000 annually. The tax-free income is now at $273,800. Then (after a calculation), there is a company match of approximately $12,000 that can be included at the company level. Thus, in effect, roughly $285,800 of business income could be earned and be free of federal income tax. It’s important to note that, unless a Social Security Totalization agreement with the country of residence is in place, the couple would still be liable for self-employment tax, which is Social Security and Medicare, and is not offset by the FEIE. However, at 15.3% overall, that is a tax of $32,405.40 – 50% of which is covered by the business. That’s a huge savings overall!
Make a Non-Deductible Traditional IRA Contribution, and then Convert to a Roth IRA Tax-Free.
While traditional IRAs are tools that reduce taxable income, there are upper-income restrictions on deductible IRA contributions. However, no such restrictions exist on non-deductible contributions. So, higher-earning expats can make a non-deductible contribution to a traditional IRA, and then convert those contributions to a Roth IRA. In that scenario, they avoid income restrictions on direct Roth contributions.
This strategy means only the earnings between the time of contribution and conversion would be taxable at ordinary income rates. In most situations, this would occur within a short period, so tax consequences would be minimized. For expats, the FEIE, when combined with the standard deduction, can allow this to happen tax-free altogether.
Use Foreign Tax Credits to Contribute to an IRA Which Can Help Move You Closer to FIRE for US Expats.
While the foreign earned income exclusion is an excellent tool for tax savings, and crucial in many of the strategies previously discussed, in some cases, claiming the Foreign Tax Credit is more beneficial and brings more beneficial results than the FEIE. By definition, when you utilize the FEIE, you have less (or even zero) earned income by IRS standards. So, if Jane D. Expat earns a salary of $100,000 but excludes it all using the FEIE, she has no earned income to contribute to an IRA. However, when claiming a Foreign Tax Credit, by default, she would have taxable wages or net self-employment income. This gives her an option to contribute to an IRA (traditional or Roth) in the US. Remember that if the US has a tax treaty with your resident country, you may be permitted to re-source IRAs to Roths and then apply the Foreign Tax Credit in order to pay for the conversion.
Depending on your specific situation, considering the tips we’ve listed above can help save you money and minimize your tax liability. Join the FIRE for US expats movement, and find out what it’s like to be financially independent.
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