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Foreign Earned Income and Roth IRA Contributions

In 1974, John Hershey, a regional sales manager for New York Life, excitedly broke the news at a staff meeting in Springfield, Missouri.  A new law had been legislated that would allow workers with no employer-sponsored retirement plan to set up their own Individual Retirement Accounts (IRAs).  Apparently anyone earning a salary would be able to contribute up to $2,000 in untaxed dollars, which meant an immediate tax savings benefit.  As the lowest tax bracket at the time was 14%, a $2,000 IRA contribution meant an immediate $280 savings in taxes for anyone in that bracket. 

The rub was that withdrawals at retirement would be included in gross income subject to federal income tax rates, though insurance companies and investment advisors were quick to suggest that retirees would be in lower tax brackets by age 65.  Although earnings on IRA accounts were sheltered, contributions and earnings would be taxed as ordinary income once withdrawn.  Further, withdrawals before age 59 1/2 would be subject to 10% penalty (certain exceptions apply under current law); otherwise they were mandatory starting at age 70 1/2.

Inevitably, some financial planners figured out that $2,000 contributed annually starting at age 21 for the first six years only ($12,000) at 12% compounded interest and would grow to over a million dollars upon retirement. Hershey was excited because the insurance industry would be the primary beneficiary of this new investment vehicle.

However, since workers with pensions were not allowed to set up an IRA, the Carter Administration extended availability to all workers.  But when Congress realized that higher-income more than lower-income workers were taking more advantage of IRA tax advantages, the legislators responded in the Tax Reform Act of 1986 by limiting tax deferability to workers without an employer-sponsored pension plan or to those whose income levels were lower.

The Roth IRA was a knee-jerk reaction to the unpopularity of those 1986 restrictions. Enacted as part of The Taxpayer Relief Act of 1997, the Roth IRA removed the restrictions and created a reverse retirement vehicle. Contributions would not be tax deductible. But the same contributions withdrawn at retirement would also not be included in taxable income.  Also, they could be left invested for future generations rather than subjected to mandatory withdrawals.  Otherwise, like the traditional IRA, Roth IRA earnings accrued tax free.

A Roth IRA is mainly a savings vehicle. It can be set up within any IRS approved institution such as banks, credit unions, brokerage houses, etc., at any time during the year. But it must be funded before the owner’s tax filing deadline.  In 2008 the maximum contribution limits are $5,000 per person ($6,000 if over 50), based on qualified income. Contribution amounts are phased out as modified adjusted gross income (MAGI) levels rise according to filing status.

Qualified income includes wages and salaries, self-employment income, alimony, commissions, and non-taxable combat pay.  It does not include earnings from properties, interest or dividend income, pension or annuity income, deferred compensation, or income from certain partnerships. Nor does it include amounts excluded by the foreign earned income or housing exclusion (which are added to adjusted gross income for MAGI purposes).  Furthermore, qualified income must at least be equal to the amount of Roth contribution.

In 2008, Single filers are phased out from $101,000 - $116,000 of MAGI, Married filers from $159,000 - $169,000, and Married Separate filers between $0 and $10,000. Suppose you are a Single filer with qualified W-2 earnings of $3,000 and foreign earnings of $107,000 (MAGI = $110,000). You can only contribute $1,200 to a Roth IRA.  But if your foreign earnings are $98,000 (MAGI = $101,000), you can contribute the full $3,000. Find out how much you might qualify to contribute at:

http://www.smartmoney.com/tax/retire/index.cfm?story=iraoptions&hpadref=1

Are there any alternatives for American expatriates earning foreign income who wish to fund a Roth IRA?  In 2008, the foreign earned income exclusion (FEIE) amount is $87,600.  Apparently any foreign earnings that exceed FEIE qualify.  In the above example, if you had no W-2 earnings but $95,000 in foreign earnings ($95,000 - $87,600 = $7,400), you could contribute $5,000 to a Roth IRA (MAGI = $95,000).  But you cannot reduce FEIE below your foreign earnings to qualify your income for a Roth contribution. Perversely you can opt not to take FEIE in favor of taking 100% of the foreign tax credit.  But this avenue can have less favorable tax consequences.

FEIE depends on foreign residence: bona fide or physical presence. In either case, the taxpayer must first qualify before any FEIE is available.  Once qualified as a foreign resident, the $87,600 exclusion can only be lowered in the second year if you return to the U.S.  Suppose date of return 1 July 2008.  The exclusion amount would be reduced by 50%, with foreign income over $43,800 qualifying for Roth purposes. But subsequently the tax filer would have to re-qualify for the full exclusion under the bona fide or physical presence tests.

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One of our readers, Joseph Keller, pointed out after reading this article on the American Citizens Abroad website (www.ACA.ch) had this to say: 'During the early years I was not aware that income that I excluded from taxation using FEIE was not eligible for Roth contributions. Years later I discovered my error and after some sleepless nights and weeks of research, I finally found the solution. You were actually very close to stating it in your article, but fell short when you discussed the ways in which the Physical Presence test can be utilized. There is nothing stopping someone who qualifies for Bona Fide residence to instead choose the Physical Presence test, and there is nothing stopping someone who choses the Physical Presence to choose a 330 day period that spills into the previous or following tax year (thereby reducing their exemption by the days of spillover). In fact, you can make it spill over to the day as much as you need so that you have "just enough" income not excluded through FEIE to make the full Roth contribution legal. Simply work backwards from the amount you need to exclude at the end of 2555.' Our thanks to Joe for his contribution to this complex subject.