Individual Retirement Accounts (IRAs) are an important part of retirement planning due to their great US tax advantages. Americans abroad however need to be aware of how expat tax benefits can affect retirement accounts such as Roth and Traditional IRAs. Expats who use the Foreign Earned Income Exclusion (FEIE) often inadvertently make an IRA excess contribution.
Many expats don’t fully understand that the FEIE can limit how much they can contribute. (Not their fault – expat tax is complicated.) This leads them to wrongly make IRA excess contributions that can be a hassle to undo later. An IRA over-contribution also triggers additional taxes.
In this article, we give an overview of Traditional and Roth IRAs and their general contribution limits. Then we explain the impact of the FEIE, excess contributions, and how to correct them.
- Difference between Traditional and Roth IRA
- IRA contribution limits
- How the FEIE impacts IRA contributions
- IRA excess contribution tax
- How expats can contribute to an IRA and avoid excess contributions
Let’s get started.
To learn more about the FEIE in general, check out our Guide to the Foreign Earned Income Exclusion.
Difference between Traditional and Roth IRA
The main difference between Traditional and Roth IRA is the tax treatment of the contributions and distributions. Both have tax advantages, but the timing is different.
With a traditional IRA, the contributions may be tax-deductible, and you pay tax on the withdrawals later. With a Roth IRA, on the other hand, the contributions are not tax-deductible, but the withdrawals later are tax-free. (As always when it comes to tax, specific rules and requirements apply.)
Furthermore, a Traditional IRA has required minimum distributions, starting at a certain age. Roth IRAs, however, don’t have mandatory distributions.
Traditional and Roth IRAs have the same general contribution limit. But for Roth IRAs, additional limitations may apply, based on your filing status and income. Therefore, if your income is over a limit, you cannot contribute to a Roth IRA. More about this in a moment.
No matter if you choose a Roth or Traditional IRA, you cannot exceed the annual contribution limit.
IRA contribution limits
Each year, the Internal Revenue Service (IRS) determines the limit that an individual can contribute to an IRA account.
For 2022, the limit is the same as it was for the prior three years. The total contributions an individual can make to all traditional IRAs and Roth IRAs combined cannot exceed the lesser of
- $6,000 ($7,000 age 50 or older), or
- the taxable compensation for the year.
The IRS increased the contribution limits for 2023. Then, the total contributions can’t exceed the lesser of
- $6,500 ($7,500 if age 50 or older), or
- the taxable compensation for the year.
“Taxable compensation” is the important term here for expats. More about that in a moment.
The above-mentioned limit does not apply to rollovers.
IRA contribution limits for married couples
When filing a joint return, both can make IRA contributions even if only one spouse has taxable compensation. Each spouse can contribute up to the current limit.
However, the total of the contributions cannot exceed the taxable compensation reported on the joint return.
Roth IRA contribution limits
In addition to the general contribution limit that applies to both Roth and traditional IRAs, high-income earners may have further limitations for Roth IRAs. Those are based on the filing status and the modified adjusted gross income (MAGI) reported in the tax return.
We recommend checking the 2022 and 2023 IRS tables to determine if you are eligible.
How the FEIE impacts IRA contributions
As mentioned earlier, contributions cannot exceed the amount of “taxable compensation”. Here lies the crux for expats that take the Foreign Earned Income Exclusion (FEIE).
With the FEIE, taxpayers abroad can exclude up to about $100,000 from their earned income. This lowers their taxable income and thus their income tax.
However, they can only make an IRA contribution from unexcluded income. If you exclude all your income with the Foreign Earned Income Exclusion, then you have no “taxable compensation” left for the contribution.
There are two ways that you can still make an IRA contribution when using the FEIE:
- Your income exceeds the FEIE exclusion. This leaves unexcluded income to make an IRA contribution.
- You earn compensation while working in the US, e.g., during a business trip or vacation. Since this is not foreign-sourced income, it cannot be excluded with the FEIE. You can calculate how much unexcluded income you have, depending on how many days you spent in the US.
Many expats are not aware that they cannot use excluded income to contribute to their IRA. So they make a contribution that is not allowed. This is called an Excess Contribution and can result in penalty taxes.
We’ve often seen expats make this mistake and helped them clean it up.
IRA excess contribution tax
If an individual contributes more than the allowed limit in a particular year, the IRS considers it an excess contribution. Again, you can only make IRA contributions from income that is not excluded under the Foreign Earned Income Exclusion.
Making excess IRA contributions has tax consequences.
You pay a 6% excise tax per year for each year the excess amounts remain in the IRA. If you don’t withdraw the excess contribution, you will continue to pay excise tax each year.
To avoid the 6% tax, you must withdraw the excess and any income earned on the excess contribution. You must do this before the due date of your individual income tax return (including extensions). You will need to include IRS Form 5329 with your filing to reflect the withdrawn contributions.
Remember, you must also remove any earnings generated by the excess contribution and include those in your gross income.
If you did not withdraw the excess contributions before the due date, you might still avoid the 6% excise tax. To do so, you must file an amended return within six months of the original return due date (generally by October 15). You will need to write “Filed pursuant to section 301.9100-2” at the top of Form 1040X. Our experienced tax accountants can help you with that.
How expats can contribute to an IRA and avoid excess contributions
As we explained, to make an IRA contribution you need “taxable compensation” which cannot be income excluded from income tax using the FEIE. If you spend some time working while in the US or your income exceeds the FEIE limit, you would have unexcluded income you can use.
Another common scenario, that many Americans abroad overlook, is using Foreign Tax Credits instead of the Foreign Earned Income Exclusion. If you live in a country with tax rates similar to or higher than the United States, it can make sense to forgo the FEIE.
In that case, you are not excluding your income from US taxation. Instead, you claim on your US tax return a dollar-for-dollar credit for taxes paid to the foreign country to reduce your US tax liability.
Not only does this lower or even eliminate your US tax burden. It also leaves you with income you can use for IRA contributions and other tax advantages, like taking a child tax credit, if applicable.
Tax accountants with experience in expat tax can calculate both tax scenarios for you, with FEIE and with Foreign Tax Credits, and see which one makes more sense in your situation. Schedule a consultation with our experienced team.
Hong Kong
Panama
