Nowadays, it is well known by most US citizens living overseas that there is an annual requirement to file tax returns to the IRS, if they have any worldwide income. But much lesser known are the implications or requirements for having a US based retirement scheme.
Many of our clients hold IRAs, 401ks, and other forms of retirement plan in the US, and we are frequently asked how these should be dealt with. For any US citizen already filing their tax returns to the IRS from New Zealand, experience alone can usually tell us what a minefield retirement schemes can be.
But, we’ll give here a brief overview of the potential implications and considerations when having a US based retirement plan. For convenience, we’ll be referring to IRA accounts only below.
The issues touched on below will be discussed in greater detail as part of a series of seminars that I am hosting alongside Julia Johnston, tax lawyer and partner of Saunders and Co Lawyers. The seminars are taking place in late June, and you can register to attend here.
Firstly, we must ensure that we separate out our considerations between Traditional IRAs, and Roth IRAs. For those who don’t already know, these two types of IRA accounts have different tax treatments.
A Traditional IRA allows you to deduct a certain amount from your “above the line” income each year, to contribute to the retirement account. Essentially, this means excluding the contribution amount from your calculations when totaling up your income for the year. The annual contributions are subject to limits, so for most earners, you can’t contribute your entire annual income to the account, and thus have no income to report.
In simple terms, this means you get to reduce your taxable income each year by your contribution amount, and thus pay less tax to the IRS.
This system above results in a Traditional IRA being funded from pre-tax income, but taxable in the USA upon withdrawal. Traditional IRA withdrawals are taxable like any other income, but you would’ve enjoyed the benefit of tax free contributions for the lifetime of the account. This is the case whether you withdraw early (before age 59 ½), or after this age. Withdrawals made before this age would be subject to a 10% early withdrawal penalty however.
A Roth IRA functions very differently, in that it is funded from post-tax contributions. This means that you can’t deduct your contribution amount each year from your income, and instead you pay tax on your income regardless of whether you contribute to the Roth IRA.
This is in basic terms, the opposite system to the Traditional IRA. The annual contribution limit to Roth IRA accounts is much higher than a Traditional IRA, but again, you don’t get the advantage of being able to reduce your income by the contribution amount.
The key benefit however, is that Roth IRAs are not taxable in the USA upon withdrawal, assuming you were to withdraw after age 59 ½. Even if you do withdraw early, not all of the withdrawal would be subject to a 10% early withdrawal penalty, so Roth accounts do offer a far greater degree of flexibility.
The New Zealand Consideration
But, you’re probably wondering at this point, how does this all fit in when you live in New Zealand?
So we’ll start with the first myth buster…
Many US citizens living in New Zealand are under the impression that you can only contribute to an IRA (Traditional or Roth) if you have US sourced income, but this is not the case.
As the USA taxes worldwide income, it is all recorded simply as just that, income. It does not need to be US sourced in order to contribute to an IRA. Broadly speaking however, to contribute to any IRA, you must have some form of income.
When contributing to a Traditional IRA from New Zealand, you may take a deduction on your US tax return for the contribution amount. However, given that New Zealand and the United States have a comprehensive tax treaty in place, its likely that you wouldn’t have any tax to pay to the IRS anyway, and therefore the deduction wouldn’t have been particularly useful. Whilst of course this varies on a case by case basis, I can say that 9 out of 10 of our NZ based clients do not have any US tax liability on their ordinary earned income (passive income such as Kiwisaver is a different story).
Most US citizens in New Zealand can take advantage of the Foreign Earned Income Exclusion (FEIE), which can exclude more than $100,000 USD of foreign wages (ie NZ) from US taxation (above the line, just like Traditional IRA contributions). This can reduce your total “adjusted gross income” right down to zero, meaning no taxable income on your US tax return.
So with this in mind, if you can already exclude your income, then the benefit of being able to exclude your income through a Traditional IRA contribution is somewhat moot.
Knowing that the Traditional IRA deduction might not be that useful, but then you’ll pay tax on the withdrawal, some might say it makes the Traditional IRA not a great investment for US citizens living in NZ.
Then, lets switch over to a Roth IRA. In order to contribute to a Roth IRA, you must have taxable income. This means, that the Foreign Earned Income Exclusion can not be used, since if you excluded your “adjusted gross income” down to zero, then you’d technically have no income to report and thus prevented from contributing to a Roth IRA.
As a result, if you are living and working in New Zealand, but wish to contribute to a Roth IRA, you must instead use Foreign Tax Credits (FTC). This is an alternative method of preventing double taxation, whereby (generally speaking) a dollar-for-dollar credit is taken for NZ tax paid, thus offsetting the US tax that would’ve applied on your income. This credit is taken against the tax liability calculated, rather than the income you’ve earned.
To put simply, FEIE excludes your income, FTC excludes your tax (put in basic terms). Therefore, if you wish to contribute to a Roth IRA, then generally, you cannot use FEIE on your tax return.
Self-filing tax returns with FTC is complex, and generally not recommended for those who only have a basic understanding of US tax return preparation.
So, based on the above, it would seem that for a US citizen living in New Zealand, a Roth IRA would be the best type of account to have, since the deduction you can take for a Traditional IRA can sometimes be pointless? Well, think again…
Both Traditional and Roth IRA’s can be subject to tax in New Zealand upon withdrawal, regardless of their tax status in the US. The amount of tax can vary dependent on the type of account, who contributed to it (ie a government employer), or the type of withdrawal (ie lump sum or periodic).
The amount of tax owing to the IRD on a US retirement fund withdrawal can also depend on how long you’ve lived in New Zealand, which is calculated over a 30 year period from NZ tax residency beginning, so it is always best to seek advice prior to withdrawal (or even contributing).
For those hoping to contribute to a Roth IRA with an eventual tax free withdrawal, the knowledge that tax would potentially be owing in NZ on its withdrawal, can often be a decision changer.
As you may have now come to the conclusion of, there is no “right way” to contribute to a US retirement account from New Zealand, as both Traditional and Roth accounts come with their own needs, and implications upon withdrawal.
This may lead to the question of “well if not a US retirement fund, then where?”. Well this question can take another 1500 words to resolve, as Kiwisaver, Unisaver and most other NZ retirement schemes can have their own implications.
Before investing in a US based retirement account, it is important to consider where you plan to retire, and equally as important to obtain both US and NZ specialized advice. At US Global Tax, we work with local experts in a variety of industries, including wealth management, NZ tax law, and financial planners to ensure our clients obtain the best, personalized advice.
As always, US Global Tax are here to help with any questions or tax filing assistance. Contact our specialized Auckland NZ-US office on 09-373-2949, or Australian office on+61-2-9211-7130