For U.S. persons ONLY these two types of Foreign Financial Accounts provide Tax Effected Yield on Income and Accumulations which are formally recognized by FATCA and by IRS tax code to purchase investments globally from a tax free environment exempt from Foreign Financial Institution reporting and exempt from passive foreign income reporting.
If you are living and working overseas, you may or may not have a legal basis to structure a tax preferred foreign retirement plan. Yes, an individual with foreign sourced income should want to turbo-charge retirement savings by seeking legal advice.
If you are living and working offshore, you can use a retirement plan to reduce your taxes. Yes, you can use a Solo 401k plan* to save tax deferred and/or an IRC 402(b)* foreign government regulated, registered and IRS recognized retirement plan to save income deferred.
The US government treats all U.S. persons the same. It doesn’t matter whether you are living in Panama City, Florida, or Panama City, Panama. Because you are subject to U.S. tax.
Note: The Expat also gets to take a standard deduction, or all of the same itemized deductions as someone living in the US; including mortgage interest. You should only consider a retirement plan if your net income exceeds the Foreign Earned Income Exclusion and your allowed deductions. For example, it is unlikely that a retirement plan will be tax efficient for someone earning below $110,000.
For contributions of more than $ 50,000.00 a year
- For the high net worth individual, who wants to contribute more than $50,000 tax deferred a year a deferred income contribution benefit plan is required.
Solo 401(k) Retirement Plan Participant
You can establish a Solo 401(k) plan, provided that the only eligible plan participants are you (the business owner) and your U.S. spouse (if you have one). Generally this means you won’t be able to set up a Solo 401(k) if you have other U.S. employees. If you have US employees, you might consider segmenting them to their own entity.
Contributing to a Solo 401(k) Plan
Similar to other 401(k) plans, Solo 401(k) plans allow contributions in the following ways:
- An employee contribution of up to $18,000 if younger than age 50, or $24,000 if age 50 or above in 2013
- An employer (or profit-sharing) contribution of:
- Up to 25% of net adjusted business profits for those not required to pay self-employment tax
- Up to 20% of net adjusted business profits for those who are required to pay self-employment tax. Net adjusted business profit is calculated by taking gross self employment income and then subtracting business expenses and then subtracting 1/2 of the self employment tax.
As an expat entrepreneurs, your salary is designated as the profit-sharing contribution. The maximum annual total limit for both types of contributions is $53,000, or $59,000 if age 50 or over for tax year 2015.
IRS Opinion Letter
This Solo 401(k) plan comes with an IRS Opinion Letter which confirms the validity of the plan and is a safeguard against any potential IRS Audit.
U.S. Tax Implications
Pretax option: Qualified contributions (employee and profit sharing) can be deducted from U.S. taxable earned income at the time of contribution. These contributions then grow on a tax-deferred basis until you begin to withdraw them after age 59½, at which time they will be taxed as ordinary income at your future U.S. marginal tax rate.
After-tax (Roth) option: If your 401(k) plan documents allow it, the employee contribution portion can also be made on an after-tax (nondeductible) basis, and contributed to a separate Roth 401(k) account that will growth free of U.S. tax. (Note that profit-sharing or employer contributions, which are not mandatory, cannot be made to Roth options at this time.)
Whether it’s better for you to make pretax or Roth contributions to a 401(k) plan will depend on your personal situation. If your taxable AGI will increase in future years, then you want to focus on Roth contributions. If your effective tax rate will decrease in the future (after retirement), then you want to focus on traditional plans.
Yes, it is possible for the your effective tax rate to increase after retirement. If most of your income was excluded by the FEIE, your effective rate might be near zero. After retirement, you might begin selling stocks, taking distributions, etc., all of which is taxable in the US. Therefore, your effective tax rate will often rise after retirement.
Special Consideration: Un-excluded Earned Income Requirement
Note that your Solo 401(k) contribution must be made with un-excluded earned income (such as wages or self-employment income). If you either have no earned income or if you’re excluding all earned income from U.S. tax using the Foreign Earned Income Exclusion, you cannot contribute to a Solo 401(k).
This is one of the reasons I stated above that you should only consider a retirement plan if your income exceeds the Foreign Earned Income Exclusion. Another is that it makes no sense to lock money in to a retirement account if you can take it as salary tax free.
If you’re currently excluding all of your earned income using FEIE, but you could receive similar benefits by using the Foreign Tax Credit, rather than the FEIE, it could make sense to revoke using FEIE in order to contribute to a Solo 401(k) plan. In other words, if you pay a lot of local tax on your salary in the country you live, you may find that switching to using the foreign tax credit won’t leave you worse off in terms of U.S. tax and will allow you to invest in a Solo 401(k).
Note: If you make this switch and then change your mind within five years, you’ll need to apply for IRS approval to resume using FEIE by requesting a ruling from the IRS.
Summary Solo 401(k) Plan
Solo 401(k)s is a great way for a U.S. person to save money each year in a U.S. tax deferred account.
There are a number of issues to consider when creating a retirement account.