IRA contributions and the Foreign Earned Income Exclusion (FEIE)
Individual retirement accounts (IRAs) are an attractive investment vehicle for many U.S. citizens and residents. However, they have limitations that an unsuspecting American living abroad can easily run afoul of. Here’s a quick rundown of what to look out for.
Not Enough Taxable Compensation
“For 2023, the total contributions you make each year to all of your traditional IRAs and Roth IRAs can’t be more than:
• $6,500 ($7,500 if you’re age 50 or older), or
• If less, your taxable compensation for the year”
Taxable compensation is the key term here. If you use the Foreign Earned Income Exclusion (FEIE), you could have made up to $120,000 in 2023 and your taxable compensation could be $0, if all of that income was excluded.
Pro tip: the standard deduction doesn’t matter when determining your taxable compensation, so you don’t necessarily have to actually pay any tax on the income for it to be eligible.
There are two ways to be able to contribute to an IRA even if you use the FEIE:
Earn income in the U.S. Amounts you’re paid for work performed while you were physically in the U.S. are not foreign earned income and therefore can’t be excluded under the FEIE – but you can contribute those amounts to your IRA, if you meet the other IRA requirements.
Make more than the FEIE limit. If your earned income is over $127,000 for 2024, the amount above that isn’t excluded income and can be contributed without any issues.
Important note: you can’t just arbitrarily choose to report part of your foreign earned income as if it was earned in the U.S. – you have to be able to explain how the amount was calculated.
Foreign Spouses
Since Roth IRAs are such an attractive investment vehicle, the IRS has restrictions to avoid people circumventing the income limitations. The one that we’re concerned with is a sharp restriction on taxpayers who file separately and live with their spouses.
“If your filing status is married filing separately and you lived with your spouse at any time during the year, and your modified AGI is ≥ $10,000, then you can contribute zero [dollars to a Roth IRA].”
This rule is designed to prevent couples with significantly different incomes from filing separately to allow the lower-earning spouse to circumvent the income limit, but it has the unintended side effect of essentially prohibiting Roth IRA contributions if you’re married to a nonresident alien.
There are two ways around this:
The “Backdoor Roth.” This widely known loophole – which also works for people who exceed the income limits – involves contributing to a traditional IRA first, then rolling over the funds into a Roth IRA. (Note that this is a frequent target of tax reform proposals and there’s a good chance it gets eliminated at some point).
Electing to treat your spouse as a resident alien for tax purposes. This can be a complicated decision, because it requires your spouse to file taxes just like you do – reporting their worldwide income, and using the foreign earned income exclusion and/or foreign tax credit to avoid double taxation. If your spouse doesn’t have a SSN, they’ll also need to apply for an Individual Taxpayer Identification Number (ITIN). You can read more about this option here.
Income Limitations
This usually isn’t an issue for most people who use the FEIE, but it does affect a lot of people who use the foreign tax credit. Here’s how your adjusted gross income affects your ability to make Roth IRA contributions:
For traditional IRAs, there are income limits for being able to take a deduction for contributions, but not on the ability to contribute. If you don’t qualify (or need) to take a deduction, you can make a nondeductible contribution, which will then reduce the tax you have to pay on distributions in the future. As mentioned earlier, you can also roll amounts over from a traditional IRA to a Roth IRA; if the amount in your traditional IRA was nondeductible, then at the time of rollover you only have to pay tax on the account’s earnings.
I live abroad, why do I still owe taxes?
There are many reasons that US citizens living abroad may still owe taxes to the IRS. Here are a few of the most common ones.
Self employment income
If you are an independent contractor or otherwise run your own business, you generally have to pay self-employment tax – that’s taxes for Social Security and Medicare – on your net business profit (income remaining after expenses).
Self-employment tax is 15.3% on 92.35% of your net profit. So if your profit was $50,000, you pay tax on $46,175, which comes out to $7,065. (This calculation will change if your net profit plus wages from US employers is greater than $160,200, since above that threshold you’re only paying Medicare and not Social Security).
If you live in one of the 30 countries that has a totalization agreement with the U.S. Social Security Administration, you may be exempt from paying this tax, generally because you are contributing to that country’s social security system instead. (Mexico is not one of those countries).
Investment income
Investment income – which includes interest, dividends, and net profit from selling property stocks – is not considered earned income and therefore cannot be excluded using the foreign earned income exclusion. (If the income is foreign and you paid taxes in another country, you may be able to use the foreign tax credit to offset US tax liability.)
Rental income
Like investment income, rental income is generally not considered earned income and therefore cannot be excluded with the FEIE.
US source income
Any income for work earned while physically in the US (even on a short business trip), or income from property located in the US, is generally considered US source income and subject to US taxes. If you also owe taxes on that income in your country of residence, you may be able to claim a credit for taxes paid to the US.
Questions? Feel free to reach out.
What are the tax implications of buying property abroad?
I recently connected with a U.S. citizen who is looking to buy property in Mexico and wanted to know what the tax implications of that purchase would be. Here’s what I told her:
The purchase itself is not a taxable event. Just like in the U.S., simply buying property doesn’t trigger any tax obligations or reporting requirements.
The purchase process might trigger an FBAR filing requirement. U.S. citizens are required to file an annual report with the Financial Crimes Enforcement Network (FINCEN) if they have more than $10,000 USD (or the equivalent in foreign currency) in foreign financial accounts they control at any point during the year. If funds for the purchase pass through a foreign account that you control during the purchase process, that would trigger the FBAR filing requirement for the year.
There may be taxes due when the property is sold. The difference between the value in dollars when you sell the property vs. its value when you bought it may result in a “capital gain” that is taxable in the U.S. If you lived in the property as your primary residence, however, you may be able to exclude all or part of that gain from taxation.
If you rent out the property, you’ll owe U.S. taxes on your profits. You may be able to claim a credit for taxes paid to Mexico.
If you buy the property through a trust or other legal entity that you control, you may have to file extra tax forms for the entity. U.S. persons with ownership stakes in foreign entities may have to file Form 5471 with their personal tax return for as long as they own the foreign entity.
If you have a mortgage, you may be able to deduct the interest on your tax return. Mortgage interest on loans is deductible for your primary or second home (up to certain limits), regardless of where it is located, as long as the loan is secured by the property.
This is only helpful if your itemized deductions are larger than the standard deduction – for 2023 that’s $13,850 for single taxpayers and $27,700 for married couples filing jointly.
Foreign real estate taxes are not eligible itemized deductions. However, if you’re renting the property, you can deduct all or a portion of those taxes from your rental income.
Also be sure to look into the tax laws in the country where you’re buying the property. In Mexico for example, value added tax (IVA) is due on the purchase price for investment properties (but not for your primary residence), and there may be capital gains taxes due at the time of sale (though like the U.S., you may be able to avoid those taxes if the property is your personal residence and you have legal residency in Mexico and a Mexican tax ID number (RFC).
Thinking about buying or selling property abroad and wondering about the tax implications? Let’s talk.
Filing Form 5472 for Foreign-Owned US Single Member LLCs
Did you know that if you have a LLC in the US, you may need to file a tax return for it?
For US citizens and residents, single-member LLCs are considered “disregarded entities” and don’t need to file a separate tax return – all activity for the LLC is reported on the owner’s tax return. However, if you’re a foreign national who doesn’t file a resident tax return, under IRS regulations your LLC is treated as a corporation for reporting purposes.
A foreign-owned U.S. [disregarded entity] is a domestic DE that is wholly owned by a foreign person. For tax years beginning on or after January 1, 2017, and ending on or after December 13, 2017, a foreign-owned U.S. DE is treated as an entity separate from its owner and classified as a corporation for the limited purposes of the requirements under section 6038A that apply to 25% foreign-owned domestic corporations. See the final regulations at IRS.gov/irb/2017-03_IRB#TD-9796.
This means that every year, you need to file Form 5472 to report any transactions between yourself and your LLC, as well as a “pro forma” corporate tax return, form 1120. (The 1120 is essentially only filed so that the IRS has a record to attach the 5472 to – you only have to fill in the name and address of the LLC and items B and E on the first page.
These forms must be filed by mail or fax (they cannot be filed electronically) – see the Form 5472 Instructions for submission details.
The penalties for failing to file these forms are extraordinarily steep:
Penalties for failure to file Form 5472.
A penalty of $25,000 will be assessed on any reporting corporation that fails to file Form 5472 when due and in the manner prescribed. The penalty also applies for failure to maintain records as required by Regulations section 1.6038A-3.…Criminal penalties under sections 7203, 7206, and 7207 may also apply for failure to submit information or for filing false or fraudulent information.
Need help filing your LLC’s tax returns? Contact us today.