The other day I received a question from a reader, Jack, on my 5 Minute Intro to Roth IRAs video post.
Jack asked:
A question for those of us abroad, or rather a request for clarification: I was of the belief that foreign-earned income which qualifies for the foreign-earned income exclusion cannot be used for a Roth IRA. You make no direct reference to this. Can you clarify at all?
Jack is correct. If you are working abroad and have no income in America, you cannot invest in a Roth IRA for the year(s) you are gone.
So why is this?
No U.S. Income? No Roth.
The Roth IRA is the governments way of helping you out with retirement savings by saying you don’t have to pay tax on your investment gains when you withdraw your money in retirement.
It’s kind of like a parent leaving a book about safe sex on their teenager’s bed. They won’t force you to do anything, but they’re subtly trying to nudge you in the right direction.
If you aren’t making income in America (a.k.a. not helping out the government by paying taxes on income) then they have no reason to allow you to take advantage of this tax haven for the period of time you are working abroad.
Therefore, you can’t save for retirement in a Roth or Traditional IRA when you’re working abroad.
How to Avoid Being Taxed Twice
Jack also mentions the “foreign earned income exclusion” in his comment. What is this?
Well, as a permanent citizen of America, you are required to pay tax on all income – even if you’re working abroad.
However, the foreign earned income exclusion states that as a worker abroad, you may be able to exclude up to $91,400 of your income from your taxes in America.
The specifics depend on the country you’re working in, but it’s very possible that you’re paycheck abroad should not be taxed in America.
In order to take part in the exclusion you must pass the physical-presence test. This sounds like a P.E. test from 7th grade, but in reality it states that you have to be in another country, or countries, for 330 days over a period of 12 months before you are eligible for the foreign earned income exclusion.
The time does not have to be consecutive, but until you do, you don’t qualify and your income can be taxed twice – once by America, and once by the country you work in now.
A Japan Example
According to my organization, the JET Program, all Assistant Language Teachers must “request the standard overseas filing package from the IRS”. This includes the the 1040 Individual Income Tax Return that most people are familiar with, along with the 2555-EZ, or the Foreigner Earned Income Exclusion form.
Also, according to my organization overseas filers have an automatic two month extension (until June 15th).
My situation is a little different since I have been in Japan for less than 330 days. I must file an extension on my taxes for 2009 since I have only been out of the country for 7 months. Come July 2010, I will pass the physical presence test (330 days), and then be allowed to exclude my Japanese income from my American taxes.
So, you don’t have to pay taxes on your income while working abroad. Great!
But how do you save for retirement without access to tax-deferred accounts like 401ks and IRAs?
We’ll dive into this topic on Sunday.
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For more information on this topic check out the IRS’ information on the Foreign Earned Income Exclusion.
I’m new to these rules, so did I miss any vital information? Do you have experience with taxes while working abroad, please share your wisdom in the comments!
Photo: Micky
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Great information, Austin. This would be a great post for the International Personal Finance Carnival coming out on Monday. You may have already submitted something though.
.-= PT´s last blog ..Credit Card Companies Playing by New Rules =-.
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Austin Reply:
February 26th, 2010 at 8:51 am
Thanks for the tip. I’ll submit it right now…
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I love that foreign earned income exclusion. I can’t imagine how unhappy I would be with our government if I had to pay taxes in both places.
This reminds me… I need to get started on doing my taxes…
.-= Brad F.´s last blog ..Book Review: The Templar Legacy by Steve Berry =-.
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Austin Reply:
February 27th, 2010 at 1:26 pm
Same here. Every time I think I need to do my taxes I magically find something else “better” to do.
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Even if you don’t qualify for the foreign earned income exclusion your income won’t be taxed twice if you use the foreign tax credit.
.-= Al´s last blog ..Tokyo Skyline from Odaiba =-.
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Austin Reply:
February 27th, 2010 at 1:27 pm
Great point, Al. I overlooked that, but here’s the info if anyone is interested: http://www.irs.gov/businesses/article/0,,id=183263,00.html
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My personal experience:
The foreign tax credit is in most “middle-class” income cases the better deal, if the foreign taxes are high enough.
The income exclusion, as the name suggests, drops the your gross income down by the amount of the exclusion, in my case, down to $0. This meant I could not claim the additional child tax credit or (in the 2009 tax year) the making work pay credit, both of which I might add are refundable credits.
By showing foreign wages of say $50000 then using the foreign tax credit instead, I can get the two refundable credits because my worldwide income was well above the minimum, and my foreign taxes are higher than in the US.
As always, YMMV!
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Austin Reply:
March 14th, 2010 at 2:27 pm
Hey David –
Thanks for the insider info. Where are you located?
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David Reply:
March 14th, 2010 at 10:21 pm
I am in Germany, which is why the foreign tax credit has been higher than the US taxes owed on the income.
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This is completely wrong. US citizens abroad CAN have iras and roths, and can fill them with any foreign earned income over and above any foreign they excluded using the feie. Please get your facts right.
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