By John Hamilton, CPA
A Roth IRA can provide such significant tax benefits, that many Americans even pay tax to convert a pre-tax retirement account to a Roth IRA. As an expat, you might be able to do a tax-free Roth IRA conversion because the IRS essentially allows you to double-dip.
Who can convert to Roth IRA without paying tax?
Perhaps you worked in the US for a number of years and have now moved abroad, but still have some investments back home. Like many US expats, you may have accumulated some sort of retirement savings when working at a US company (likely a 401k, 403b, or other “qualified” retirement plan). Or maybe you have a traditional deductible IRA that you have been contributing to over the years.
It doesn’t matter whether the funds are in your old traditional 401k or an IRA. If you are using the Foreign Earned Income Exclusion for your US expat taxes, you may be able to convert a portion of those pre-tax funds each year to a Roth IRA, without ever paying a dime!
To qualify for this strategy you must have
- all or close to all of your income excluded by the Foreign Earned Income Exclusion (FEIE) and Housing Exclusion and
- if you have un-excluded income it must be less than your deductions.
So what does that mean exactly?
This means that if you earn a lot more than the FEIE amount, you probably won’t qualify. Likewise, if you have a significant amount of investment income, interest, or rental income (greater than the standard deduction total of $12,400 for single filers, $24,800 for joint filers with no children, 2020) you may not be able to qualify unless you have significant other deductions.
This may be a bit confusing. Therefore make sure to consult your CPA to determine if you qualify. If you don’t qualify or do the conversion incorrectly, you may end up with an unexpected tax bill and even penalties.
How to do a tax-free Roth IRA conversion? (With Example)
If you do qualify, you can convert the amount of traditional IRA or rollover 401k funds to a Roth IRA that is equal to or less than the unused deduction amount. Let’s call this the deduction “surplus.”
This common scenario illustrates the concept of using deduction “surplus” for a tax-free Roth IRA conversion.
A single US expat, let’s call her Rachel, is earning $100,000 per year living in Singapore. She also has an old 401k worth $80,000 back in the US. She may or may not have a Roth IRA already – it’s not important, as she can easily open one (ask us how we can help if you need to).
In addition to her salary, Rachel has about $2,000 in taxable dividends, with no other taxable income.
Since she earns less than the Foreign Earned Income Exclusion max of $107,600 (2020), she can exclude all of her salary from taxation. With no significant deductions to speak of, she claims the standard deduction of $12,000, which she can use against her non-excluded income.
Because all of her salary is excluded by the FEIE, she only has the $2,000 dividend income as potentially taxable dividend income. However, the $12,400 deduction amount reduces her taxable income to zero.
What is left is $10,400 of “surplus”, or unused, standard deduction ($12,400 less the $2,000 of investment income = $10,400).
This surplus can be used against any type of income, including Roth IRA conversions.
Rachel can now convert up to $10,400 from traditional pre-tax 401k or IRA funds, to her post-tax Roth IRA, completely tax-free.
More benefits of the tax-free Roth IRA conversion
The tax-free Roth IRA conversion is tremendously beneficial. Not only was Rachel able to get the pre-tax deduction on those funds when she contributed them to her 401k before she was an expat. She now can convert up to $10,400 this year, tax-free, never to be taxed again!
If Rachel were in the US, she would be in the 24% tax bracket and would pay approximately $2,500 on this conversion. Since she is a US expat, she can do it for free.
If Rachel stays abroad for 8 years and her situation and tax laws don’t change too much, she may even be able to convert her entire traditional 401k to a Roth IRA and never have to pay taxes on it. At the 24% tax bracket, this is an almost $20,000 value upfront, not even considering any other factors such as growth, future tax rates, etc.
You can likewise use this strategy if you have no earned income and still have some deduction surplus, but the Alternative Minimum Tax (AMT) can come into play here, so be careful.
How to plan your tax-free Roth IRA conversion
A Roth conversion must be completed by the end of the calendar year. In order to plan how much pre-tax funds you can convert tax-free to Roth, you’ll need to know before the calendar year-end with reasonable certainty how much income you will earn in each category.
If you convert too much you generate a tax liability. If you convert too little, you leave free money on the table.
A few things to consider before you do any conversions this year:
- Are you taking the Foreign Earned Income Exclusion or Foreign Tax Credit? You likely can’t use this strategy in conjunction with the Foreign Tax Credit.
- Can you exclude all of your earned income, or nearly all of it, by the Foreign Earned Income Exclusion?
- Will you have sufficient “surplus” deduction amounts to cover your conversion and make it worth the trouble?
- Do you already have a Roth IRA? If not, you can easily set one up prior to the conversion.
Note that if you made a portion of your aggregate traditional IRA holdings using non-deductible contributions, it will affect the calculation. This is known as the IRA Aggregation Rule. For this article and example, we assumed that all IRA contributions are pre-tax, either through a traditional deductible IRA, 401(k) or 403(b) plan.
Tax-free Roth IRA conversion done right
Of course, every person’s tax situation is different. But for a significant number of US expats, this tax-free Roth IRA conversion can be a windfall and really boost your retirement savings.
Before doing any of this, we highly recommend that you consult a CPA that can help you execute this strategy. While the benefits can be significant, if it’s done incorrectly, it could end in a nasty tax bill and even a 10% penalty on the converted funds.
Set up a consultation to discuss this and other US expat tax strategies.
Photo by Anthony Ginsbrook