Last August I took the advice of practically every wealth management consultant and economist I have ever met, and began saving for my retirement. I am only 24 years old, and often careless with my money, but I have enough sense to respect the concept of compound interest. I figured if I put up to US$5,000 (Dh18,365) a year aside in a tax-deferred retirement account for the next 10 years and then left it alone for 35 years after that, I would have well over half a million dollars as a cushion for my golden years. Unfortunately, my grand plan left out Uncle Sam, perhaps the most important variable of the equation.
As an American living in the UAE and making less than $91,500 a year, I am exempt from paying income taxes. But as I learnt last month in the nick of time, I am also ineligible for IRAs, Roth IRAs, 401(k)s or other US government programmes designed to incentivise saving. The US is the only large developed country in the world that levies taxes on its citizens even when they are living overseas full-time, and seemingly trivial choices that American expatriates make about their savings can have big financial consequences.
And expats are frequently on their own, with few resources to guide them, says Dennis Allen, a tax partner at PricewaterhouseCoopers who has been advising Americans living in the Gulf for 13 years. "A lot of accountants in the US don't really understand the foreign income exclusion for US citizens and green card holders," he says. "A lot of the options you would have in the US, you're not able to take those options." Between August and March of this year in the first significant investment of my life, I put $8,000 into a Roth IRA account invested in a general stock index fund through Vanguard. I watched as my savings rose with the fourth-quarter market boom and dreamt naively about what it would mean to pull in 8-10 per cent annually for 35 years.
A Roth IRA allows all but the wealthiest American citizens and residents to put up to $5,000 per year into a long-term savings account. You pay taxes on the money you put into the account as part of your income tax, but if you reach the age of 59 1/2, or become disabled before withdrawing the money, you pay no taxes on the appreciation of the investment over those decades. With such a lengthy time frame, the tax savings can be considerable. Let's say that you contribute $5,000 to a Roth IRA tomorrow, with the plan of withdrawing it in 30 years. The 15 per cent capital gains levied on an investment return of $5,000 amounts to $750, while the level of tax in 30 years, given a conservative forecast of a 5 per cent annual rate of return on the investment, would be $3,241 when you cashed in your gains.
But to me, an investing novice, it appeared that I had found a wonderful loophole to pay no tax at all, since my income was tax-free and, if I could bide my time with the Roth IRA, my investment gains would be free of tax as well. As it turned out, it was too good to be true. An accountant broke the news to me in April: only taxable income is eligible to be contributed to an IRA or Roth IRA, and a 401K cannot be set up here unless you work for an American company.
If I did not withdraw the money it would be subject to a 6 per cent tax every year until it was taken out of the account. But even worse, if I withdrew it after the June 15 deadline for filing tax returns from overseas I would get hit with severe penalties designed to deter savers from using a Roth IRA as anything but a long-term savings account. The entire withdrawal would have been subject to a 15 per cent penalty (on both the principle and investment gains), and after that would still have been treated as taxable income.
In my case, my net loss would have been thousands of dollars. Thankfully, the IRS includes a sort of idiot clause for people like me that allows you to withdraw contributions made to a Roth IRA of IRA before June 15 without facing a penalty. So now I am left with a little more than $8,000 that I would still prefer to steer towards something more productive than Friday brunches at five-star hotels. With the IRA and Roth IRA route closed, what should savers in my position do?
Mr Allen recommends directing savings into mutual funds and other long-running investments and holding them for at least a year, so they are subject to the capital gains rate of 15 per cent rather than the higher income tax rate. You are going to pay tax of some sort on your impulse to save, so you may as well limit the impact. Also note that the interest earned in bank savings accounts, either here or in the US, is treated as taxable income, though it will likely be too low to rise above the standard deduction of $5,700 for single people or $11,400 for married couples, so you will not be taxed on it. Expatriates who make more than $91,500 a year and are therefore taxed on their income should consider putting up to $5,000 - the annual limit - it into a traditional IRA. The contribution counts as a deduction and can help get you back under the income threshold.
"If they're not working for US companies the traditional IRA would be a good hedge, because you would get a good current-year deduction on that," Mr Allen said. With a traditional IRA, the inverse of a Roth IRA, you pay no taxes on the contribution, but you are taxed on the entire investment if you withdraw it when you are 59 1/2. If you withdraw it before then and do not meet certain special conditions, such as having a physical disability, you get hit with an additional 10 per cent penalty tax. A person of any means can contribute to an IRA, while contributions to a Roth IRA are limited to people who make less than $105,000 per year.
One final point to consider: in 2010 the government has eliminated income requirements for converting a regular IRA into a Roth IRA, which could allow for significant savings in the future if you still have many years before retirement. The withdrawal from the IRA is taxable income, but the IRS has waived the penalty fee, and you get to spread that income over two years to minimise its effect on your income tax rate.
Most expats may want to wait until they return to the US to convert, since they probably face a higher tax bracket here, Mr Allen said. cstanton@thenational.ae
