How to: Contribute to an IRA while an expat

This week, The Prepared Expat takes a deep dive into how you, as an expat, can contribute to an Individual Retirement Account (IRA) while an expat US citizen and while still claiming the Foreign Earned Income Exclusion. If none of those things make sense to you, keep reading on because today’s how to can save you tens of thousands, if not hundreds of thousands of dollars in taxes and investment opportunity costs.

Read more: How to: Contribute to an IRA while an expat

Note: while most of The Prepared Expat is for a global audience, not just US citizens, this guide is specific for US citizens.

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One of the disadvantages to being a US citizen is that, even when you live outside the United States, you are subject to paying US income tax on your worldwide income, regardless of where it is sourced. Oddly, enough, the only other country in the world that does this is Eritrea (so the US is in good company?). However, the US tax code provides a great provision called the Foreign Earned Income Exclusion (FEIE) which will benefit many expat US citizens.

The Foreign Earned Income Exclusion (FEIE) means that your first roughly $105,000 of foreign-earned income is excluded from the US federal taxes. That is, if you make less than $105,000 and claim FEIE, then you don’t pay any tax to the US government. This is a great benefit, but it presents a problem if you want to contribute to a retirement IRA (whether Roth or Traditional), because IRA contributions require that you have earned income in order to make a contribution. If you don’t have earned income, then you can’t contribute to an IRA.

So, for example, if your foreign earned income is $85,000 and you claim FEIE, then the FEIE exclusion of $105,000 counts against your $85,000 earned income as a kind of anti-income. Thus, the IRS would consider your entire $85,000 to not be earned income. That’s great since it would mean you pay $0 in taxes, but without earned income you also can’t contribute to an IRA. Most expats I know think this means that they have to choose between contributing to an IRA or claiming FEIE, but this its not true.

However, that’s not true. Now, I’m not a financial or tax expert, but Joshua Sheats of Radical Personal Finance is (just look at the letters after his name: MSFS, CFP, CLU, ChFC, CASL, RHU, REBC, CAP); in episode 642 of his excellent podcast, he focuses on exactly this question. What follows is my summary of his explanation, with a transcript of the podcast after my summary.

How to contribute to an IRA while still claiming FEIE

First, simply make more money than FEIE excludes. That is, if you make $115,000 and claim FEIE, only $105,000 will be excluded and you’ll still have $10,000 that counts as earned income. You can still claim your normal deductions against that $10,000, but it counts as earned income and thus you can contribute up to that amount into an IRA.

Second, you can contribute to an IRA if you claim FEIE by using the strict days test (and not the bona fide resident test) and adjust your date period. The strict days test requires that you spend 330 days out of a 365 day period outside of the US; if you are in a foreign country for those 330 days, then you qualify to claim FEIE. However, you don’t have to claim that 365 day period from January 1 to December 31 of a given year; you can choose any rolling 365 day period and the FEIE will apply to you on a pro-rated basis.

Here’s an example of how it works. Let’s say that you’re outside the US for 14 months (January of 2022 to March of 2023). When you fill out Form 2555 to claim FEIE, on line 16 of part 3, you choose the time period of February 1, 2022 to February 1, 2023. You were outside the US for 330 of those 365 days, and thus you qualify for FEIE, but because you do not include January as part of the time period to qualify for FEIE, your January income will not be excluded via FEIE and thus will count as earned income. Thus, you can contribute to an IRA up to the amount that you earned from January. If you make $85,000 a year, that’s $232/day; 31 days in January would mean you have $7,192 that counts as earned income; you could thus contribute $7,192 to an IRA.

The above is just one example; you can adjust the time period you claim for FEIE however you like. Keep in mind that you will pay tax on any income that isn’t excluded by FEIE. You thus will want to adjust the time period you claim for FEIE to your advantage: long enough for you to contribute what you want to an IRA, but short enough that you don’t generate a high tax bill. You’ll need to adjust your dates to find the right time period to claim, just make sure that you were in another country for 330 days of the 365 day period that you’re claiming.

This works because Form 2555 is not a declaration to the IRS of when you were outside the US, it is just a declaration of which dates you are claiming to qualify for FEIE. Thus, by claiming the time period February 1, 2021 to February 1, 2022, you are not representing to the IRS that you were in the US during January of 2021; you’re just choosing the time period by which you qualify for FEIE. So long as you really were outside the US for 330 days of the 365 day period that you claim, you’re being truthful and qualify for FEIE.

Roth IRA or Traditional IRA?

One last thing, by claiming FEIE for most of your income and not claiming it for only a small portion of your income, your tax bill will most likely be near $0. What that means is that you’ll be far better off contributing to a Roth IRA rather than a Traditional IRA. If you’re not familiar with the difference, you contribute to a Roth IRA after you pay taxes on your income so that, when you withdraw funds from the Roth IRA, you don’t pay taxes then. On the other hand, with a Traditional IRA, you contribute before you pay taxes on your income and thus, when you withdraw funds from the Traditional IRA, you pay taxes then.

If you claim FEIE, though, your income tax rate is nearly if not actually zero, which means your contributions into a Roth IRA aren’t taxed now and won’t be taxed when you withdraw them, making your investment nearly, if not actually, tax-free. If you contributed to a Traditional IRA, though, then you would still pay taxes when you withdraw funds.

So take advantage of FEIE and a Roth IRA to make retirement investments basically tax-free!

Read the transcript of Radical Personal Finance Episode 642 below.

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Radical Personal Final Episode #642, partial transcript:

[You can contribute to an IRA] based upon how you claim your foreign earned income exclusion. There are two tests that can be used to qualify for the foreign earned income exclusion. The first test is a strict days test. It’s a test that simply goes based upon how many days you spend outside of the US. If you will spend at least 330 days out of a 365 day period outside of the US, in a foreign country, then you will qualify for the foreign earned income exclusion, regardless of any other fact…We’ll come back to that in a moment.

The other way you claim the foreign earned income exclusion is with what’s called the bona fide residence exception. So this is where you actually live somewhere else and you have a series of factors that demonstrate that, yes, you actually live somewhere else. If you can prove that you actually are a bona fide residence of another place, you actually live somewhere else, you’re not just bouncing around the world—you have a residency visa or you’re a citizen of another country, you have stable [a] house there, you work there, your family is there, etc., you’re a resident there and you plan to be a residence there forever—then you can qualify for the foreign earned income exclusion under the bona fide residency test. And that will give you the ability, if you needed to or wanted to, to spend more physical days in the US than the strict days test. Generally, you could probably spend up to about 4 months in the US. You can’t spend more than 4 months in the US every year because that would cause you to fail the substantial presence test if you were spending more than 120 days in the US every year and thus automatically subject you to US taxation. But if you spent a couple, 3 or 4 months in the US each year, you could do that as long as you are a true bona fide resident abroad. That won’t work and allow you to contribute to an IRA if you’re claiming the foreign earned income exclusion under that test, because that test is an annual test. It only works on calendar years.

But here’s the cool thing with the strict days test…It doesn’t have to be January 1 to December 31. So, you don’t have to be gone from the US from January 1 to December 31 in order to claim the foreign earned income exclusion. You simply have to qualify for it during any rolling 365 period that you choose. Which means that you could, if you wanted to, spend January, February, March, April, and May, in the US; you could leave the US on June 1 and be gone until June 1 the following year, and then return to the US for July, August, September, October, November, December of the following year and still claim the foreign earned income exclusion. Now the way that would work is you claim that 12 month period but then it is pro-rated to your 12-month tax year. So, if…under that fact pattern that I just described from June to June, if you claim the exclusion during that period of time, you would say “Listen, I would have 50% of my earnings that are subject to tax and I would have 50% that are able to claim the foreign earned income exclusion.” And the exclusion itself is pro-rated so you would have access to, say, $52,500 of the exclusion. But the thing is that you control that date.

Now let’s assume, with a case of simpler facts, that you are outside the US all the time. You haven’t come back in 5 years, you have zero days in the US. So thus automatically you’re going to qualify for the foreign earned income exclusion under the days test. Now what you’ve most likely been doing up until now is claiming your year from January 1 to December 31, just for simple convenience that’s what you’ve been claiming. Here’s what I would point out to you, though, you don’t have to claim that.

So here’s what you can do to create earned income that will allow you to contribute to an IRA: claim a different time period. Now, it doesn’t matter, you’re not representing to the IRS that you were in the US for a different time period, you’re just saying you’re claiming a different period.

For example, let’s say you earn $100,000 a year…your daily wages are $274…now you’re trying to generate some…earned income to contribute to an IRA, but you also want to make sure you qualify for the foreign earned income exclusion. Well, you don’t come back to the US, but $274 times…31 days is $8,494. So what you can simply do is, when you fill out your tax return and when you fill out form 2555 for the foreign earned income exclusion, on…part 3, taxpayers qualifying under the physical presence test, line 16 of part 3 says “The physical presence test is based on the 12 month period from this date through this date.” So when you are filling out form 2555 you simply write on that paper that the physical presence test is based on the period from February 1, for example 2018 through February 1, 2019. Then you go on and you explain that you haven’t traveled in the US, you were physically present in a foreign country for the entire 12 month period, but because you wrote on that line February 1 to February 1, you automatically now have 31 days that are not subject to the foreign earned income exclusion. Which means that your earned income is going to be pro-rated and you will pick up $8494 of income from that 31 day period. Thus that $8,494 will flow through your tax return and it’s available for you to make an IRA contribution.

So if you want to claim earned income, just claim a different set of dates on form 2555. And you can do that every year. You can do that February 1 2018 to February 2019 and then when you do the following year’s tax return, you can claim February 1 2019 to February 1 2020. All that you’re claiming is the days that you’re going to subject to that physical presence test. And so you’ve now created 31 days that you’re not going to claim the income for.

I would just say you’re going to need to play with this numbers, because this is very much one of those situations where you’re going to jigger the numbers. You’re not going to change your facts…we’re just jiggering the numbers to see what will help you the best.

Comment for you on IRA contributions: I don’t see any reason for you to contribute to a traditional IRA under this plan. What’s the point on deferring taxes to a later date when you can just go ahead and pay zero taxes, if you’re not already maximizing the foreign earned income exclusion amount? I can see why you would participate in a Roth IRA…but you judge appropriately.

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