Our tax system sure does love acronyms. In today’s version of alphabet soup, we will discuss IRAs - specifically, how they play in the sandbox with the FEIE.
First things first, what in the world is an IRA?
An IRA is an Individual Retirement account. These accounts are tax-advantaged and allow you to save for retirement tax-deferred or tax-free. There are four types of IRAs: Traditional, Roth, SEP, and SIMPLE.
Traditional IRA
The traditional IRA is one that, in most cases, you can contribute to, and your contribution is tax deductible. Money contributed to a traditional IRA grows tax-deferred, and you pay taxes at your ordinary income rate when you withdraw the funds and earnings.
There are limits to how much you can contribute to an IRA ($6,000 for 2022 and $6,500 for 2023), and the deductibility of that contribution is subject to MAGI (modified adjusted gross income) limits. What does that mean? It means you can still contribute if you make too much money, but it’s not deductible for tax purposes.
Roth IRA
The Roth IRA is a non-deductible (or after-tax) contribution that allows your money to grow tax-free. With a Roth IRA, you pay taxes now so that you don't have to pay tax later when you withdraw the funds and earnings.
The Roth IRA has the same contribution limits as the traditional ($6,000 for 2022 and $6,500 for 2023) but is subject to income limitations. This means if your MAGI is above a certain limit, you’re not allowed to contribute to the Roth account at all.
SEP IRA
The SEP, or Self-Employed Plan, behaves much like the traditional IRA, but a self-employed individual have the option to put a lot more money into it each year. SEP contributions are tax deductible and grow tax-deferred, just like the traditional IRA. The contribution limit for the SEP IRA is 25% of compensation up to a much higher limit ($61,000 for 2022 and $66,000 for 2023). Many of you who are self-employed ask, “What’s my compensation?” The answer is net earnings from self-employment – so income after expenses.
SIMPLE IRA
The SIMPLE IRA is very similar to the SEP IRA. The main difference is that it allows employees (if you have them) to contribute a tax-deductible amount in addition to the employer's contribution. The contribution limit for a SIMPLE is also lower than SEP ($14,000 for 2022 and $15,500 for 2023). SIMPLE IRAs are uncommon, especially now that the Solo 401k is around.
So, what happens when we add the FEIE (foreign earned income exclusion)?
The FEIE is a tax exclusion allowing you to exempt income earned while abroad from federal income taxes. Traditional and Roth IRAs are tax advantaged plans that require taxable compensation, and often the FEIE eliminates taxable compensation. You cannot contribute to a tax-advantaged plan with tax-excluded funds. It’s basically double dipping, which is not allowed.
SEP and SIMPLE IRAs do not have this limitation.
Argh! What’s a nomad to do regarding the FEIE and IRAs?
If you want to contribute to a Traditional IRA or a Roth IRA, you should check with your tax advisor or financial planner before contributing to ensure you’re eligible.
Some of you will have taxable compensation due to either making above the FEIE limit or spending time working in the United States. Though if you don’t have taxable compensation, your contributions could be limited or disallowed entirely.
Can I allocate income to the US if I want to contribute?
Nope, that’s a misstatement of how your income is earned, and could jeopardize your FEIE claim, as well as get you in hot water with the IRS.
What if I already contributed too much?
If you over-contributed, you must withdraw those amounts before your tax filing date, or you will be subject to an annual penalty until the funds are withdrawn.
How do I get around this?
If you’re self-employed, the better options for retirement savings are either the SEP plan discussed above or the Solo 401k. The FEIE limits neither of these plans since they are figured before FEIE calculations.
If you’re employed and your employer offers a 401k, you should participate, especially if your employer offers a match. A 401k employer match is basically free money, and should not be passed up if possible. If your employer doesn’t offer a 401k or similar plan, you should discuss your options with your tax advisor or financial planner.
What’s a Solo 401k?
The most attractive retirement planning option out there has always been the 401k. A 401k allows the employee to contribute up to a certain amount ($20,500 for 2022, $22,500 for 2023) and an employer-matching contribution amount. These two amounts can add up to the annual limit ($61,000 for 2022 and $66,000 for 2023).
Until a few years ago, 401k plans were not accessible to small businesses, given the immense oversight and reporting that goes along with them. But the financial industry got it together and now offers a solution: the Solo 401k, or the “i401k” – a “pooled” 401k. This plan is available to self-employed freelancers, solopreneurs, and small businesses with less tax entanglement.
A self-employed person or small business owner can now open a Solo 401k and save a good deal of retirement savings with it. You can make the employee contribution of up to the annual limit and 25% of compensation as an employer contribution (this is the same 25% you can put away with a SEP) up to the yearly limit.
How about a backdoor Roth?
The backdoor Roth is a strategy used to get around the high-income limitation of the Roth IRA. If you’re over the MAGI limits and unable to contribute to a Roth, you can make a traditional IRA contribution and then convert it to a Roth. Note that this is a taxable event. A backdoor Roth works if your limitations are due to high-income, but it does not get around the taxable compensation issue that the FEIE causes.
Simply put, contributing to retirement in the United States is not simple. At Nomad Tax, we’re super pleased to make IRA contribution recommendations as a part of our tax service, but you can and should also consult with your financial advisor if you have one. As always, we’re happy to answer any questions you have regarding IRAs.