How to invest for the future is one of the major dilemmas that not only Americans living in the US face, but is also a major concern for US citizens living abroad. When do you start saving? Where should you put your money? But as an expat, whether you plan to remain living and working outside the US for many years or will only be abroad a few years, decisions about how to invest become a lot more important because of the complexity of US expatriate taxes. The complexity of foreign country tax rates, tax laws on different types of investments and retirement plan options are, at the very least, daunting. We’ll help you cut through the confusion so you can make informed decisions on how you should be saving and investing for retirement. Trying to create a tax efficient portfolio in a retirement plan or taxable investment account can be a challenge to the taxpayer, their tax adviser, and their investment adviser.
Let’s start at the beginning- What is a Tax Efficient Portfolio?
Tax efficiency is defined as “a measure of how much of an investment’s return is left over after taxes are paid”. So, when you are looking at your investment portfolio (think: Retirement accounts, investment accounts, etc.) you first look at your return on investment (ROI), then you subtract from that the taxes you will pay on that return. The higher the final ROI of your investment, the more efficient your portfolio will be.
For example, you have a $1000 bond that, at maturity, gives you a $100 return, which is a return of investment (ROI) of 10%. Your tax rate is 25%, reducing your return to $75 with an ROI of 7.5%.
You own 100 shares of XYZ Corporation that you sell for a long term gain of $1000, a 10% ROI. The long term capital gains tax rate for this investment is 15%, or $150 of tax. Your total ROI for the sale of the stock is 8.5% ($1000-150 = $850 gain).
In this example the XYZ stock sale is more efficient than the bond sale, even though the initial ROI is the same. This is an example of how your tax rate will affect your investment return.
To understand tax efficiency in an investment portfolio, you need to figure out the final ROI of each investment and how it adds or detracts from your investment goals for the future. US expats especially need to be careful of how they choose their investments, as tax laws become complicated and convoluted in regards to foreign investing and savings accounts. Expats also need to take into consideration the tax they will pay in their resident country on the same investment, and add it in when calculating the total ROI of each investment. All the taxes can add up quickly.
Regardless of where you live in the world, there are normally three types of investment options to consider when investing. They are investments that are fully taxable, tax-deferred and tax exempt.
- Fully taxable investments: Investments that do not have any tax advantages like a US mutual fund or brokerage account. While this may sound like a bad idea, there are a lot of advantages. These investments can be more liquid (where you can access your money faster), they can come with lower administrative costs, and can be tailored to fit into your tax bracket with less taxes accruing.
- Tax-deferred investments: Investments where the income earned is not taxed until a later date. Typical types of tax-deferred investments are IRAs, 401(k)s, and other US retirement accounts. These accounts allow you to defer income from being taxed when you have a higher tax rate (during your income earning years) to when you have a lower tax rate (when you retire). The US only recognizes US based and established plans for tax deferment. Foreign plans that are fundamentally similar (like the Australian Superannuation plans) do not qualify for US tax deferment. So be careful when doing your research on your resident country’s plans.
- Tax exempt investments – These are investments where the return is free from US federal income taxes. The most typical type of tax exempt investment is a US municipal bond.
If you live in the US, you have some great options for investing that won’t break the bank in taxes and fees. Once you join the ranks of the US expat though, your options become a little bit more limited. Most non-US retirement accounts are considered fully taxable investments, no matter how they are treated in your resident country.
Now that you understand the different types of investments, here are some things to know if you want to work towards tax efficient investing: Your marginal tax rate (highest tax rate) in the US, the tax law regarding your investment in your resident country, and the tax law in the US regarding your foreign investment, which can increase the taxes due on the income from particular investments.
Know Your Investment Type and Applicable Tax Laws
Knowing what kind of investment you have, and how it will be treated in the US is the most important step to growing your portfolio. There are many countries that have a tax treaty with the US, preventing you from being “double taxed” on your income. This is usually achieved by using the Foreign Tax Credit, allowing a credit on your US return for taxes paid to the foreign country or vice versa. For example, UK residents can minimize the UK tax on offshore investments by choosing to invest in US funds that have achieved “UK Reporting Status”.
Foreign Stocks and Bonds
Another option would be to invest in a specific foreign stock and/or bonds. If you are not looking for much risk, you would want to purchase a large amount of different investments to match the diversification you normally get by owning a mutual fund. In other words, you would be creating your own mutual fund to minimize market ups and downs in your investments. Your interest income would be taxed at your country’s tax rate and at the US ordinary income rate, but you would receive a tax credit from one country or the other depending on the tax treaty.
US Expatriate Tax Reporting
In addition to the taxes owed to the US and your resident country, there are a lot of additional US expatriate tax reporting requirements with investments abroad. These additional filing requirements almost always require additional tax preparation costs to meet the obligations. While not a tax, the additional preparation fees increase your total expenses relating to foreign investments. And they can add up so don’t overlook them.
As an expat you have probably heard of FATCA (often pronounced fat-ka). FATCA is the “Foreign Account Tax Compliance Act”, which was signed into law March 2010. This law requires the reporting by US taxpayers of certain foreign financial accounts, and offshore assets. It also requires foreign financial institutions to disclose certain information about financial accounts held or substantially owned by US taxpayers.
FATCA regulations require US taxpayers, both in the US and abroad, to report ownership (or interest) in financial accounts and assets on form 8938, filed with their tax return. Currently, news reports from all over the world are reporting that foreign financial institutions are not allowing US citizens to use their services because of these cumbersome reporting requirements. This will certainly limit the investing options for the US citizen living abroad.
You might run across problems with tax efficiency if you own passive foreign investment company mutual funds (PFIC – pronounced P-fick). As it may be difficult to transfer and invest your income in US brokerage accounts while living in a foreign country, you might be tempted to invest locally with a non US mutual fund (or similar investment). The income and growth in these funds are required to be reported and gains taxed on your US tax return each year on form 8621. (There are some special elections you can make to defer the tax, but rules apply!) The IRS Form 8621 must be filed for each individual fund that is considered a PFIC. For example, a UK Shares IRA could hold 10 or more separate PFICs in one account!
If all these filing requirements weren’t enough, in 2013 Congress implemented a special 3.8% surtax, called the Net Investment Income Tax (NIIT) on the investment income of higher income taxpayers.
Creating a tax efficient portfolio for a US citizen living abroad is a complicated process and requires a lot of research and weighing of options. Choosing the right financial adviser and tax adviser to fit with your plan is important. Make sure they understand your needs and the requirements of your resident country as well as US tax laws. It is also important to be aware that you may need to create a mix of investments to achieve the results you desire, using both US and foreign investment accounts. Ultimately you should determine your financial goals, your retirement plans, and your family needs, to grow your accounts to the best possible fruition. Hopefully, the the results will be worth the effort and planning.
Need help understanding complex regulations around US expatriate taxes on investments?
Greenback can help. Our expat-expert CPAs and IRS Enrolled Agents are here to help. Contact us today and we will get back to you within 1 business day.