Tax Insights

Your Guide to State, Local, Federal, Estate + International Taxation

Foreign earned income exclusion & retirement savings

earned income, foreign earned income exclusion, IRS, tax, international taxDo you think your accountant asks you too many questions? Do you feel interrogated?

I’d just like to remind you that we are on your side and we aren’t the ones issuing penalties. We are here to help prevent those penalties, but we can only use the information that is given to us (shocking, I know). Here is one example from this past tax season that could have easily gone unnoticed had questions not been asked.

Have you heard of the “Foreign Earned Income Exclusion”? This relates to U.S. citizens & residents living and working outside the U.S. (See qualifications or ask your accountant). If qualified, the foreign earned income exclusion excludes $101,300 (2016) or $102,100 (2017) of “Earned Income” from being taxed.

What is Earned Income?

Earned income, defined by the IRS, includes all the taxable income and wages you get from working or from certain disability payments. This includes W-2 wages and business income that is subject to self-employment tax. This does not include, interest, dividends, and capital gains. See the IRS page here for more examples.

So where am I going with this?

As you and I know, you can only contribute to your ROTH & Traditional IRA up to 100% of your earned income that has NOT been excluded. Keyword “NOT,” so “net” earned income as some of us might say. Anyways, traditional IRA here isn’t what I am worried about (although it’s the same issue) because in order to get the tax savings on that, you have to inform your accountant. Once they are made aware, they should be able to determine if there are any issues. The ROTH on the other hand is something that often goes unnoticed or is not made AWARE. So let’s piece it together in an example to explain why it should be made aware…

The year is 2016 and you work and live over in Germany making, $100,000 USD. That’s good money, but your company doesn’t have a retirement plan, so you decide you’re going to max out your ROTH contribution of $5,500. Now it comes time to file your tax return (you’re excited). You take advantage of the foreign earned income exclusion and you exclude $100,000 making your tax liability $0 AND you maxed out your ROTH IRA with $5,500 that you won’t have to pay tax on later. It’s brilliant! You just avoided paying US tax on all your wages and retirement money! Your accountant doesn’t know about your ROTH while preparing your tax return and you don’t disclose it, your tax return is done and you think you are in the clear. Negative.

The IRS one day catches up years down the road and issues an audit or notice. The issue here is that your net earned income was $0 ($100K earned income – $100K exclusion) meaning you had no earned income to contribute to the ROTH IRA. So now what? You contributed in excess of your max (which was $0) and nothing happened. Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA. This includes any income the excess amount has made. In order to correct the issue, you need to withdraw both the income attributed to the excess contribution and the excess contribution amount. And I know, 6% doesn’t seem like much, but it can be over time and will seem like a lot more when hit all at once.

Moral of this example is to communicate with your CPA or accountant and FILL out your organizer. We try to catch as much as possible, but that is also why we have the organizers, because there is so much that could easily get missed.

Chris Morrison, CPA