Updated March 30, 2017
US tax code can be very confusing. Within the complexity there can be opportunities to reduce your tax bill, but there are also potential pitfalls that can trip people up.
Recently, I have been hearing about financial advisors recommending Roth 401k plans for American expats. Here is an excerpt from one advisor’s blog (which has since been taken down):
"John is an international school teacher who earns $75,000 per year. John is paid a NET salary in China and therefore has no ability to make pre-tax contributions. He also excludes all of his income using the foreign earned income exclusion and has no other taxable earned income. We were able to help John set up a Solo Roth 401k plan and now he is able to save up to $18,000 per year towards his retirement, more than three times what he would be able to contribute to a Roth IRA. This money is treated as after-tax contributions so it will receive tax-free growth and tax-free income during retirement."
The benefits to John sound tremendous. But there are some problems with the strategy:
• Regardless of where you live, one of the key requirements for a solo 401k plan is being self-employed.
• Revenue Ruling 70-491 has been cited by an IRS employee to say income excluded with the foreign earned income exclusion cannot be contributed to a 401k plan.* The Reuters Checkpoint tax database indicates revenue ruling 70-491 has not been superseded or become obsolete.
However, people arguing the strategy is allowed cite Sec 415 of the tax code as providing cover for the strategy. I have tried getting clarity from the IRS on this, but have not been able to get an updated response yet.
A popular misconception is that if you are able to set up and contribute to an account, the strategy is allowed. However, brokerage companies are not responsible for checking to see if you satisfy IRS requirements – that is your responsibility. And companies setting up these plans typically have disclaimers saying they are not providing any tax advice.
What happens if the strategy is not allowed? The contributions may end up being taxable in full. Rather than help reduce John’s future tax bill, using the Roth 401k incorrectly could translate to paying taxes on everything in that account, leaving him worse off than if he just used a regular brokerage account (receiving recognition of his cost basis and lower tax rates on long term cap gains and qualified dividends).
Always seek the advice of a tax professional to review your situation before taking action.
*The IRS response that the strategy is not allowed was provided via email to Peggy Creveling, as cited in this blog post.