Converting traditional IRA assets to a Roth IRA can be a good deal for many U.S. expats, since it can lead to significant future tax savings and larger retirement accounts. While conversion results in an upfront tax liability, the benefits of compounded tax-exempt earnings growth and no required minimum distributions can more than compensate for the pain of having to pay taxes on the rollover amount today. (For a more detailed discussion of the Roth IRA, see our previous blog, “American Expats and IRAs: A How to Guide.”)
Prior to 2010, a rollover was not even an option for many expats. Taxpayers with a Modified Adjusted Gross Income (MAGI) above USD 100,000 were not allowed to convert assets in a traditional IRA to a Roth IRA. This income limit prevented many Americans, particularly those with generous expat packages, from taking advantage of this option. This changed in 2010, and now all U.S. taxpayers can make the Roth conversion regardless of income. The income limits for contributions (not conversions) to Roth IRAs have not changed, however. This means that a conversion may be the only way for highly compensated expats to take advantage of the tax-exempt earnings and other benefits that the Roth provides.
For most taxpayers, the decision to convert primarily depends on comparing the tax rate on any amounts converted now versus the tax rate on future distributions from a traditional IRA. In general, if the expected future tax rate is equal to or greater than the rate paid on any Roth conversions, it will make sense to convert. It may seem highly optimistic to project tax rates well in the future when it can be difficult to project tax rates one year out, but the following considerations may make the task easier.
- No State or Local Tax: Most expats are not subject to U.S. state and local taxes. Thus, even if they are in higher federal tax brackets as expats, their overall tax rate may still be significantly lower than what they would pay in retirement in the United States when considering all federal, state and local taxes. In doing this calculation, consider the state where you intend to retire. Some states have low or no income taxes, while others can be extremely high. For expats on tax equalization packages where a state tax is figured in, you may be able to arbitrage the state tax rate used in the tax equalization calculation with the actual tax rate of the state where you intend to retire.
- Use of Foreign Tax Credits: Expats with high incomes who live and work in high-tax countries may find themselves in situations where they have accumulated more foreign tax credits than they can use. This is because the host country taxes income at a higher rate than the United States. In this case, due to the way the foreign tax credit is calculated, a Roth conversion can result in a greater utilization of foreign tax credits. This can lower the effective tax rate on the conversion and can make the difference between deciding to convert or not. As always, you will need to run the numbers to see if this makes sense for you.
- Historically Low Federal Tax Rates: Despite the recent two-year extension of the Bush tax cuts, the dismal state of the both U.S. federal and state budgets argues for higher taxes in the future, especially for those in high-income brackets.
- Ability to Time Conversion: Expats on their last pre-retirement assignment may be able to control their retirement date and extend their period overseas in order to create a “window” where they have little earned income and are not subject to U.S. state and local taxes. This “window” can then be used to convert some or all of their traditional IRA assets before returning to the U.S. and becoming subject to state and local tax. This can also work for the self-employed and others who may be able to control and shift income to create opportunities for a conversion.
Tip: There is no requirement to convert all of your assets in a traditional IRA to a Roth in one year. You can make partial conversions over many years. This will allow you to manage your tax rate. Suppose your current income puts you in the 25% tax bracket. You may have some room for additional income before being pushed into the 28% bracket. Work with your tax advisor to figure out how much room you have and convert that amount. By using partial rollovers, you may be able to convert large traditional IRA balances to a Roth over several years.
Roth Conversion Details:
Eligibility: Any U.S. taxpayer is eligible. In addition, married couples filing separately (which covers many U.S. expat/non-citizen marriages) are now allowed to convert.
Income Limits: The income limits were removed in 2010.
Tax Impact: The amount converted from a traditional IRA to a Roth is considered ordinary income in the year of conversion and is added to all other income. This can push taxpayers to higher tax brackets and result in a hefty tax bill. Luckily, partial conversions are allowed, which provides some opportunity for managing the tax impact.
Special Considerations for Expats: Use of the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion (FHE) to exclude foreign earned income does not reduce the tax impact of the rollover. Like the rules used to calculate the U.S. tax liability on earnings above the FEIE and FHE, all income, including excluded foreign earned income, is used to determine the marginal tax rate that will be used to tax the Roth conversion amount.
Deadline for Rollover: December 31 of the year you want the conversion to take effect. For example, if you want to convert assets to a Roth in 2011, you must do the conversion prior to December 31, 2011.
Tip: The rollover is not irreversible. You have until October 15 of the following year to unwind (re-characterize) your conversion if you miscalculated or it no longer made sense. So for conversions made in 2011, you would have until October 15, 2012, to unwind it and avoid the tax.
A Roth conversion will not make sense for everyone, but for many expats it’s worth exploring the opportunity with a tax or financial advisor. The future tax savings can be substantial.
About Creveling & Creveling
Creveling & Creveling is a private wealth advisory firm specializing in helping expatriates living in Thailand and throughout Southeast Asia build and preserve their wealth. Through a unique, integrated consulting approach, Creveling & Creveling is dedicated to helping clients cut through the financial intricacies of expat life, make better decisions with their money, and take the steps necessary to provide a more secure future. For more information visit www.crevelingandcreveling.com.