IRA

IRA stands for “Individual Retirement Arrangement” (according to the IRS, though even I still call them “Individual Retirement Accounts”), and the IRA in its different forms remains one of the simplest and most flexible US tax-deferred ways American taxpayers can save for retirement.  The biggest disadvantage many see in IRA accounts are the relatively low maximum contribution limits, though even these relatively small amounts can add up to hundreds of thousands if not millions in tax savings over the long term.

GFM is one of Hong Kong’s leading advisors on US IRA accounts.  Clients can open GFM-managed US IRA accounts at Interactive Brokers (via this link), or by opening a US IRA with Vanguard, and appointing Tariq to direct investments in the account.

Can I contribute to an IRA?

Major requirement to keep in mind: in order to contribute to an IRA, you must have earned income that could be subject to US tax.  “Earned income” means income from working, not income from interest, royalties, or other “passive” sources.  For expats and other US citizens and green card holders living overseas, this also must be income beyond that covered by exclusions like the foreign earned income exclusion.   If you live in a low tax jurisdiction like Hong Kong, Singapore, or Dubai and still send thousands of dollars of US taxes back to the IRS on your salary, that probably means you qualify.

For reference, here is a quick list of 8 main types of IRA accounts US taxpayers should know about:

Traditional IRA

The traditional IRA is the oldest and probably best known type of IRA, that simply works this way: An employee with US taxable earned income (so not dividends, interest, rental income, royalties, etc., but a salary or bonus from working) can contribute up to US$5,500 in 2018 ($6,500 for those aged 50 and older) into a Traditional IRA, and by doing so, get an up-front tax deduction of the amount contributed.  Investments in the account grow tax-deferred, and are taxed as income when withdrawn, which can be done without penalty after age 59 1/2.

Since the IRS wants to know when it will start getting some tax money from your IRA withdraws, tax-deferred IRAs are subject to required minimum distributions (RMDs) starting at age 70 1/2.

Traditional IRAs make the most sense for high income employees who are not covered by a US qualified retirement plan at work (as many American expats working overseas are not), since this removes the income limit to taking the tax deduction on contributions, which can easily save a high-rate taxpayer US$2,000 a year.

Roth IRA

A Roth IRA is just as simple as a Traditional IRA, but the one big difference is that contributions get no up-front tax deduction (that is, a Roth IRA is funded with “after tax” money), but once inside a Roth IRA, investments grow and can then be taken out tax-free.  Roth IRAs make the most sense for younger savers who believe they will be in a higher tax bracket in retirement than they are now, and for whom the gains on their investment this year are likely to be multiples of the amounts they contribute today.

Roth IRA contributions are limited to those with an adjusted gross income (AGI) below certain limits, but higher income savers often consider a “back door” Roth IRA to accomplish the same thing.

Roth Conversions and the “Back Door” Roth IRA

A traditional, traditional rollover, or non-deductible IRA can be converted into a Roth IRA through a “Roth Conversion”.  A Roth conversion is, as the name says, a conversion of pre-tax funds in a non-Roth IRA into after tax funds in a Roth IRA where the investor must pay tax on the amount converted.  One strategy is to time Roth conversions around gap years, sabbaticals, or other tax years where you expect to be in a below average tax bracket, so that you can take the deduction in higher-tax years, and then pay tax on the conversion in lower tax years.

Even for professionals whose income doesn’t dip, those with income above the Roth limits commonly do Roth conversions of traditional or non-deductible IRA money as a more complex, but fully legal, way of funding a Roth IRA, known as “back door” Roth IRA.

Rollover IRA

When you leave a job that provided you a defined contribution retirement plan (typically a 401(k) or 403(b), but it could also be a SEP IRA as described below), you are generally allowed to either a.) leave your money in the old 401(k) plan, b.) roll your money into your new employer’s 401(k) plan (if they have one and allow transfers in), or c.) roll your money into a rollover IRA account at a brokerage firm of your choice.  I have always done option (c) myself, and recommend clients do the same, in part because it is easier for us to help direct investments in an IRA than in a 401(k) we have little control over.  GFM is one of the leading advisors of 401(k) rollovers for American expats.

Rollover IRAs can be “traditional” or “Roth”, but the main difference in the “rollover IRA” label is to mark the money as having come from a 401(k) or 403(b) plan, in case you ever wanted to roll it back into one, say at a new employer that has an awesome GFM-managed 401(k) plan. Once you mix rollover IRA money with non-rollover IRA money, you lose this option.

Because 401(k) and 403(b) limits are many times higher than individual IRA limits, rollover IRA accounts tend to be the largest IRA accounts I see.

Non-deductible IRA

A non-deductible IRA doesn’t sound as attractive as the other options, but is one way higher-paid employees above the Roth contribution limits and covered by a 401(k) plan can get a little extra money into a tax-deferred plan.  As the name says, contributions are not deductible up-front, and the gains are tax-deferred and taxed on the way out.  The IRS uses form 8606 to track these non-deductible contributions.

SEP IRA

SEP IRA stands for “Simplified Employee Pension“, and is, as far as I know, the simplest US tax deferred employer-sponsored retirement plan available.  Unlike a 401(k) plan (which requires a complicated trust arrangement, annual form 5500 filing, etc.) a SEP IRA is set up by writing a simple plan document (you can even use the IRS’s own half-page form 5305-SEP as this document), and by opening and funding SEP IRA accounts for eligible employees.  SEP IRAs annual contribution limits that are much higher than IRAs and comparable to those of 401(k) plans: for 2018, the lesser of US$55,000 or 25% of compensation.

Contrary to what I have often been asked, SEP IRAs are NOT only for the self-employed, as was the case for Keogh plans, which have mostly been overtaken by SEP and SIMPLE IRAs.

The main disadvantage of SEP IRAs, and the main reason larger companies prefer the cost and admin of a more complex 401(k) plan, is that SEP IRAs are so simple that they are inflexible: the employer must make the same percentage contribution to all qualified employees’ SEP IRA accounts.  The employee has no control over these contributions, unless of course they can control the employers decision on these contributions.  Because of this, SEP IRA plans are usually best for:

  1. Companies with only one employee
  2. Companies with a few employees who can all agree to contribute the same percentage of their pay into the plan
  3. Companies with a few long-term employees in category #2, and the rest all relatively short-term and unlikely to stay long enough to qualify for contributions, or
  4. Companies with only a few US taxpayer employees, who have the same percentage contributed, and the rest of the employees being non-US taxpayers.

SIMPLE IRA

SIMPLE IRA stands for “Savings Incentive Match PLan for Employees”, and as the acronym implies, a SIMPLE IRA is somewhat more complicated than a SEP IRA.  A SIMPLE IRA allows employees to choose contributions and employers to match these contributions, subject to lower limits of around US$18,500 per year in 2018.  The higher complexity, lower limits, and lack of interest in these plans is one reason we do not currently support any SIMPLE IRA plans.

Self-directed IRA

A “self-directed” IRA is one often advertised as giving the saver “checkbook control” over their retirement account.  To open a self-directed IRA, several custodians and service providers will help you with the transfer and compliance paper work so that you can use your IRA money to invest in non-traditional assets like physical real estate or private businesses.  We do work with a few custodians, and are happy to refer you to one if you contact us.

The Inherited IRA and Stretch IRA

So far, the above types of IRAs have mostly been described from the point of view of a working professional, looking to either save taxes now or defer taxes on investments for a large retirement nest egg in the future, but some younger investors (by “younger”, I often mean those under the age of 70 1/2) become owner of an IRA by inheriting one.  The “inherited IRA”, is simply an IRA re-titled from someone who has passed away to a beneficiary, as this AARP article describes in more detail.

One strategy to maximize the long-term tax benefits of an IRA is to name much younger beneficiaries that will “stretch” the RMDs over a much longer period of time, a technique often referred to as the “stretch IRA“.

Hopefully this guide helped you better understand the different types of IRA accounts.  Please contact us through the form below if we can help you with any IRA questions.