Thun Financial Advisors Research ©| 2019

By David Kuenzi, CFP® Thun Financial Advisors Research 2019

Thun Financial Advisors 3330 University Ave. Suite 316 Madison WI 53705 www.thunfinancial.com Skype: thunfinancial

Thun Financial Advisors, L.L.C.

is a U.S.-based, fee-only, Regis-

tered Investment Advisor that

provides investment manage-

ment and financial planning

services to Americans residing

in the U.S. and overseas.

We maximize long-term

wealth accumulation for our

clients by combining an index

allocation investment model

with strategic tax, currency,

retirement and estate plan-

ning. We guard our clients’

wealth as though it was our

own by emphasizing prudent

diversification with a focus on

wealth preservation and

growth.

IRAs, Roth IRAs and the

Conversion Decision for

Americans Living Abroad

Executive Summary

• Explains difference between “Traditional” and “Roth” IRA

• Suggests possible complications for Americans Abroad in contrib-uting to these accounts.

• Considers the factors relating to the conversion of a Traditional IRA to a Roth IRA

• Analyzes several factors in conversion that are unique to Expats

Introduction: Expat IRAs and Roth IRAs

Even under the most conventional of circumstances, American taxpayers

struggle to fully understand the myriad of tax advantaged retirement

investment options they have. IRAs, 401(k)s, Roths, Individual 401(k)s,

403(b)s, deferred compensation plans, and defined benefit employer

pension plans are some of the many possible investment choices from

which American taxpayers might choose. Each has slightly different tax

implications and a separate set of complex compliance rules, contribu-

tion limits, mandatory withdrawal requirements and other features. For

Americans abroad, matters are further complicated by a broad range of

Thun Financial Advisors Research ©| 2019

special tax considerations, both U.S. and country-

of-residence, that factor into the equation. The

good news is that Americans abroad generally

have the same opportunities as do Americans at

home to accrue tax benefits from tax advantaged

retirement accounts. In fact, under certain cir-

cumstances and with proper planning, U.S. expats

may be able to manage their foreign residency to

gain special advantage.

In this note, we guide U.S. expats to compliant and

efficient use of IRAs and Roth IRAs. It also ad-

dresses the potential advantage of Roth conver-

sion and broader oversea U.S. citizen tax strategies

to use. For the sake of simplification, this discus-

sion assumes all traditional IRA contributions are

pre-tax contributions only. The effect of U.S. state

and local tax rate are not factored, except where

explicitly discussed.

Understanding the Difference between a “Traditional” IRA and a “Roth” IRA

Many investors will be familiar with the concept of

the IRA (Individual Retirement Account), com-

monly referred to as a “traditional IRA.” These ac-

counts allow taxpayers to contribute up to $6,000

(for 2019, $5,500 for 2018) of their earned income

to an IRA account each year ($7,000 if over age 50,

for 2019) and receive a corresponding tax deduc-

tion (similar tax-deferred employer sponsored re-

tirement plans such as 401(k)s have higher contri-

bution limits). Therefore, a taxpayer in the 20%

marginal tax bracket will get the immediate bene-

fit of saving $1,200 on their current year tax bill

($6,000 x .2) if he makes a maximum contribution

to a traditional IRA. Investments in an IRA ac-

count grow tax-deferred until retirement. At age

59 ½ distributions can begin. Distributions are, in

most cases 100% taxable at the owner’s marginal

tax rate. Furthermore, starting at age 70 ½, mini-

mum annual distributions based on the account

owners life expectancy become mandatory.

In addition to annual contributions, traditional

IRA accounts may also be funded by the rollover of

an employer plan (401(k), profit sharing plan, 403

(b), etc.) into a traditional IRA. Where the investor

has assets in such a plan but is no longer partici-

pating, rolling the assets into a traditional IRA is

free of tax. This is typically referred to as a 401(k)

rollover. American expats are eligible for 401(k)

rollovers just as any other eligible person is.

Restrictions apply that may prevent contributions

from being made. Contributions amounts cannot

exceed the actual amount of earned in-

come. Individuals covered by a qualified compa-

ny retirement plan may be partially or completely

prevented from contributing pre-tax dollars to an

IRA.

Thun Financial Advisors Research ©| 2019

Special Expat Considerations: American citizens

not resident in the U.S. may contribute to an IRA,

however, they must have earned income that is

not excluded by the Foreign Earned Income Exclu-

sion (FEIE) and the Foreign Housing Exclusion

(FHE). For example, an American citizen employed

abroad by a foreign corporation earning $85,000 a

year who is able to exclude all of her income from

US taxation under the FEIE will have no “non-

excluded” income from which to make an IRA con-

tribution, and therefore cannot contribute. A

higher income expat with $202,000 of earned in-

come who applies a combination of the FEIE and

FHE, or foreign tax credits to reduce their U.S. tax

liability will be able to make a contribution.

Of course, if the combination of FEIE , the FHE or

the foreign tax credit has eliminated all U.S. tax

liability, a traditional IRA contribution will pro-

vide no immediate tax benefit, but would be taxed

when withdrawn in retirement and therefore is

not advised. Thus we conclude that generally IRA

contributions, if allowed, may make sense in coun-

tries of residence with low tax rates but not in

those with high tax rates. Even if a Traditional IRA

is not permitted or does not make financial sense,

a Roth contribution might make sense for an ex-

pat.

The “Roth IRA” Variant

The Roth IRA works in a reverse manner to the

traditional IRA. Contributions to a Roth IRA gen-

erate no immediate tax savings. However, when

distributions of both principal and investment

earnings are taken in retirement, they are com-

pletely free of tax. Contribution limits for Roth

IRAs are the same as for regular IRAs. Unlike tra-

ditional IRAs, single filers with modified adjusted

gross income (MAGI) above $137,000 and mar-

ried, joint filers with (MAGI) above $203,000, can-

If your filing status is... And your MAGI is... Then you can contribute...

Married filing joint-ly or qualifying widow(er)

< $193,000 up to the limit

> $193,000 but < $203,000 a reduced amount

> $203,000 zero

Married filing separately and you lived with your spouse at any time during the year

< $10,000

a reduced amount

> $10,000 zero

Single, head of household, or-married filing separately and you did not live with your spouse at any time during the year

< $122,000 up to the limit

> $122,000 but < $137,000 a reduced amount

> $137,000 zero

2019 MAGI Limits for Roth IRA

Thun Financial Advisors Research ©| 2019

not make annual Roth contributions.

There is an option to convert an existing tradition-

al IRA (as well as other tax-deferred retirement

plans) to a Roth IRA. All or part of the traditional

IRA can be converted. Conversion is available for

all traditional IRA accounts without respect to in-

come. Conversion, however, requires the account

holder to report the full value of the amount con-

verted as regular income in the year converted.

An important advantage of the Roth IRA is that it

has no minimum distribution requirement. The

entire balance of the account can simply be left to

grow free of tax and then bequeathed to estate

beneficiaries. Those beneficiaries, in turn, can

stretch withdrawals out over their entire life-

times. That realistically implies that Roth contri-

butions made now by younger individuals could

remain in the account, growing tax free for 100

years or more before being fully withdrawn. The

compounding effect of such long-term tax free ap-

preciation implies a very, very large boost to inter-

generational wealth accumulation. Of course, leav-

ing the Roth IRA untapped through retirement im-

plies that the account owner has other financial

resources on which to draw.

Special Expat Roth IRA Considerations: Many

American expats who have married non-

Americans elect to file married, filing separately.

Taxpayers with this filing status are generally not

allowed to make any IRA contributions. Roth con-

versions are still permitted.

To Convert or Not convert an IRA?

As previously noted, conversion of a traditional

IRA to a Roth IRA requires the account holder to

report all of the amount converted as regular in-

come in the year of the conversion. That may re-

sult in a very large tax bill due at the time of con-

version for individuals depending on the size of

the amount converted. So it is important to care-

fully analyze the tax consequences of Roth conver-

sion.

The choice between Roth or traditional is a choice

between taxation at current tax rates or at future

tax rates (in retirement). Generally, it is better to

Thun Financial Advisors Research ©| 2019

defer taxes (and collect investment return on the

amount of taxes deferred) than to pay now. This

is especially true when future tax rates will be

lower than current tax rates. However, the Roth

also allows all future appreciation to be totally tax

free. The value of tax free growth may more than

offset the negative impact of paying now at higher

rates.

Therefore, the calculation of whether or not it

makes financial sense to contribute to a Roth IRA

or convert a traditional IRA to a Roth IRA largely

depends on two variables: the marginal tax rate at

which taxes will have to be paid on amounts con-

verted or contributed now, and the marginal tax

rate prevailing at the time money is withdrawn

from the traditional IRA, if conversion is not car-

ried out. Analysis shows that when retirement tax

rates are expected to be the same or higher than

current rates, the Roth contributions and Roth

conversion is unambiguously the right choice. On-

ly when marginal tax rates in retirement are ex-

pected to be substantially lower than current mar-

ginal tax rates does the traditional IRA prove opti-

mal.

Judging Current and Future Tax Rates: Deter-

mining current and future tax rates is a complex

exercise. First, future tax rates are uncertain. Sec-

ond, good financial planning can help reduce tax

rates now and in the future which in turn will alter

the pay-off of employing Roth. Within this context,

Taxable Income Tax Rate

$0—$9,700 10%

$9,701—$39,475

$970 plus 12% of the amount

over $9,700

$39,476—$84,200 $4,543 plus 22% of the amount

over $39,475

$84,201—$160,725 $14,382 plus 24% of the amount

over $84,200

$160,726—$ 204,100 $32,748 plus 32% of the amount

over $160,725

$204,101-$510,300 $46,628 plus 35% of the amount

over $204,100

$510,301 or more $153,798 plus 37% of the

amount over $510,300

Taxable Income Tax Rate

$0—$19,400 10%

$19,401—$78,950 $1,940 plus 12% of the

amount over $19,400

$78,951—$168,400 $9,086 plus 22% of the

amount over $77,400

$168,401—$321,450 $28,765 plus 24% of the

amount over $165,000

$321,451—$408,200

$65,496 plus 32% of the

amount over $315,000

$408,201—$612,350 $93,257 plus 35% of the

amount over $400,000

$612,351 or more $164,709 plus 37% of the

amount over $600,000

NB: There is also a “Head of Household” status

2019 Tax Rates Single 2019 Married Filing Jointly

Thun Financial Advisors Research ©| 2019

the value of Roth conversion will be determined

by:

• Proper calculation of the current marginal tax

rate. Marginal tax rate refers to the rate at

which your last dollar of taxable income is

taxed. This can range from 10% for individuals

with less than $9,700 of taxable income in

2019 to 37% for individuals with more than

$510,300. Taxpayers considering a Roth con-

version must be aware that conversion may

raise the marginal tax rate at which at least

some of the converted amount is taxed. For ex-

ample, an individual with taxable income of

$110,000 in 2019 falls into the 24% marginal

tax bracket. If he has a $100,000 traditional

IRA to convert and converts all of it in 2019,

the effect of the additional income will be to

push him into the 32% marginal tax bracket,

causing part of the converted amount to be

taxed at the 32% rate and part at the 24%

rate. In such cases, it may be optimal to spread

the conversion out over several years so that

the conversion itself does not push the taxpay-

er into a higher tax bracket. Careful analysis of

an investor’s tax situation is required.

• A changing year-to-year financial and tax situa-

tion. Individuals who experience large swings

in their annual income may be most able to

benefit from Roth. For example, consider a

taxpayer with $100,000 in a traditional IRA

account, who experienced a temporary period

of unemployment during 2019 and as a result

has little or no income for the year. The tax-

payer finds new, high-paying work in 2020 and

in general is likely to be well-off in retire-

ment. This is an ideal situation for Roth con-

version. Most of the $100,000 in the tradition-

al IRA can be converted at a relatively low tax

rate in 2019. This can result in large tax sav-

ings. In such a scenario, it may be optimal to

contribute and/or convert even if the investor

ends up in a relatively low marginal rate dur-

ing retirement.

• Estimating retirement year tax rates. Deriving

a realistic estimate of marginal tax rates twen-

ty to thirty years in the future requires a lot of

careful financial planning and some educated

guesswork. Taxpayers must analyze and esti-

mate likely sources of retirement income

(social security, pensions, investment in-

come). Consideration of the national economic

and financial environment must also be fac-

tored in: most analysts expect tax rates to rise

over the medium to long term in the United

States, although this is not by any means a

foregone conclusion.

Special Expat Roth Conversion Considerations:

Expats have to go through the same process of es-

timating current versus future marginal tax rates,

but deriving accurate rates estimates requires sev-

eral addition factors:

• State taxes are an important part of the Roth

conversion calculation for Americans abroad.

In many cases (but not all) Americans living

abroad are not subject to state taxation. If they

intend to return home and retire in a state that

Thun Financial Advisors Research ©| 2019

taxes traditional IRA distributions (as most

states do), then the ability to convert without

paying state taxes on the conversion (and

thereby permanently removing the assets from

both state and federal taxes) effectively lowers

the bar in favor of conversion.

• Host country taxation must also be considered.

If the Roth IRA conversion amount is subject to

a local taxation at a higher rate that the appli-

cable U.S. rate, it may be better to forego Roth

conversion or defer it until returning to the

U.S. (if return is anticipated). Furthermore,

most countries may not recognize Roth IRA

distributions as tax-free. The taxpayer thereby

risks being double taxed: once on the amount

contributed when it was earned and again

when it is distributed in retirement.

• Americans who anticipate living abroad per-

manently may want to consider a host of

unique planning opportunities to reduce their

retirement marginal tax rate. The availability

of such strategies may militate against Roth

conversion. For example, consider the case of

an American citizen living in Hong Kong, mar-

ried to a Hong Kong citizen who is not an

American citizen or a U.S. permanent resi-

dent. Suppose the American citizen has large

amounts of unrealized capital gains in an in-

vestment portfolio and anticipates selling

those holdings to fund retirement. In that case,

the American citizen should consider annual

gifts of stock to his Hong Kong spouse (in

2019, an American citizen can gift up to

2017 Tax Law and Roth Conversion

The 2017 passage of the tax law changed a

great deal (including raising the standard de-

duction), but kept in place one of the key tools

in the Expat’s tax reporting toolbox: the FEIE

or Foreign Earned Income Exclusion.

The Foreign Earned Income Exclusion allows

Americans working abroad to partially escape

the burdens of the United States' unique sys-

tem of "Citizenship Based Taxation," which

means that an American citizen, no matter

where they live, will be subject to United States

taxation. The FEIE allows an American working

and living abroad to easily exempt up to

$105,900 (2019) of income earned in a foreign

country from U.S. taxation per filer (note:

should a partner make only $50,000, their

$55,900 of excess cannot be used to offset any

income their partner makes over 105,900).

As the tax law currently stands, filers who use

the FEIE are still eligible to use the standard

deduction on any active income earned in the

United States ($12,200 for Americans filing sin-

gly, $18,350 for Americans filing as "Head of

Household," and $24,400 for Americans who

were married filing jointly). One type of income

that would still be eligible for the standard de-

duction would be income earned from an IRA

distribution. In theory, then, an American cou-

ple (without children) using the FEIE, can

"convert" up to $24,400 from a traditional IRA

to a Roth IRA tax free every year they are

abroad.

Thun Financial Advisors Research ©| 2019

$155,000 per year to a non-U.S. citizen spouse

without paying gift tax). The spouse, in turn,

can sell the stock and pay no capital gains since

Hong Kong does not have a cap- ital gains

tax. Properly employed, such a strategy may

reduce the American citizen’s retirement tax

rate to a level well below his tax rate at the

time the conversion decision had to be made.

The myriad of circumstances and possibilities

raised by living abroad are too many, and too spe-

cific to each individual case to list completely

here. Suffice to say, the Roth conversion decision

requires careful consideration and the required

analysis is further complicated by additional fi-

nancial planning factors unique to Americans

abroad.

Tax Diversification between IRA Accounts

For many younger taxpayers or the merely moder-

ately well-off, making a close to definitive conclu-

sion about whether conversion is financially opti-

mal may not be possible. There can be too many

uncertainties about retirement year financial cir-

cumstances for an accurate calculation to be

made. This is one of the reasons that taxpayers

may want to pursue a strategy of “tax diversifica-

tion.” In this scenario, the taxpayer contributes

some annual amounts to a Roth and some to a tra-

ditional IRA. Likewise, part of an existing tradi-

tional IRA is converted and part is not. This ap-

proach effectively hedges the taxpayer against the

risk of being in a much higher or lower marginal

tax environment during retirement than they an-

ticipated when they made the decision between

traditional and Roth.

Special considerations for expats: Tax diversifi-

cation makes especially good sense for Americans

abroad because the complexity of the conversion

calculation is augmented by their special tax and

planning circumstances. The more complicated

the calculation, the higher the risk that the wrong

Thun Financial Advisors Research ©| 2019

decision will be made and therefore the greater the benefit of a

“hedged” approach as offered by the tax diversification strategy.

Conclusion

Although specific analysis of each situation is required, most wealthy

Americans will find the Roth contributions and strategically executed

Roth conversions make sense. For taxpayers not expecting to be in

the higher tax brackets during retirement, the decision is not clear-

cut.

For many moderately financially well-off Americans, Roth may ulti-

mately generate a very large tax savings, but changing personal fi-

nancial circumstances changes and changes in future tax policies

(both in the U.S. and/or in the country of residence) could cause this

not to be the case. Factors uniquely affecting Americans abroad will

have broad impact on the calculation. As always, it is best to consult

with a qualified investment advisor or tax consultant before making a

final decision.

Thun Financial Advisors Research is the leading provider of financial planning research for cross-border and American

expatriate investors. Based in Madison, Wisconsin, David Kuenzi and Thun Financial Advisors’ Research have been featured in

the Wall Street Journal, Emerging Money, Investment News, International Advisor, Financial Planning Magazine and Wealth

Management among other publications.

“Thun Financial Advisors is a Creative Planning, LLC company. Creative Planning, LLC (“Company”) is an SEC registered investment adviser located in Overland Park, Kansas. This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.”

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