Problem: Benefitting from the significant tax advantages of qualified retirement accounts is difficult because of their complexity, especially when the special tax implications of living abroad are factored in
Understanding how to properly employ tax advantaged retirement accounts is particularly vexing for Americans abroad because they often do not have the easy option of simply adopting the company 401k plan. Rather, Americans abroad must proactively learn how to employ IRAs, Roths and SEPs to fill the gap. Over a lifetime of saving and investing, these accounts can provide enormous benefits not only in terms of tax savings, but also in terms of asset protection in litigation situations and estate planning. But investors need to very carefully navigate the complex rules governing these accounts to avoid mistakes that might trigger unnecessary taxation or even loss of tax deferred status. Furthermore, optimizing the tax advantage of these accounts also requires careful calculation of how stock and bond investments are allocated between taxable and tax-deferred or tax exempt accounts.
For the self-employed, proper use of retirement savings accounts is particularly important because of the onerous tax regime imposed by the IRS on Americans with self-employment income derived from non-US sources. Generally, Americans employed abroad by non-US employers can escape the self-employment tax altogether. But any American living abroad with self-employment (Schedule C) income must pay the full 15.3% tax (unless exempted by a bilateral "totalization agreement"). The burden is compounded by the fact that the IRS limits deductions when determining the amount of self-employment income subject to the tax. However, this burden can be offset by the unique ability of self-employed individuals to shield large amounts of income from the federal income tax through the recent innovation of the "solo 401k." A simplified version of the cumbersome company 401k, the "solo 401k" offers self-employed entrepreneurs a chance to defer up to $49,000 a year of self-employment income.
Recommendation: Learn how to make full use of tax advantaged retirement accounts
As investors, we are limited in our ability to affect the long-term performance of stock and bond markets. As taxpayers, however, we have the power to pay more or less taxes depending how well we manage the tax impact of our investment strategies. Proper tax management can add as much as 3% of total annual return to a stock portfolio*. At that rate, you can add an additional 100% of total return to your investment account in 24 years, simply by making good strategic tax choices.
Proper employment of tax deferred or tax exempt investment accounts is a critical element of long-term investment success. We recommend Americans abroad take full advantage of these opportunities. The trick is to understand how they work. For that, be prepared to do a lot of homework or seek out the advice of a qualified advisor. Finally, steer clear of non-US retirement accounts. These structures have no special tax status as far as the IRS is concerned and often will in fact incur the highly punitive wrath of the PFIC rules.
* Jeffrey, R.H. and R.D. Arnott. “Is your Alpha Big Enough to cover its Taxes?” Journal of Portfolio Management, Spring 1993.