FEIE and Roth IRA Contributions (revised)

Barron Harper, a member of the ACA Professional Tax Advisory Council, provides some history and tips for understanding how the foreign earned income exclusion influences allowable contributions to Roth IRAs.

In 1974, John Hershey, a regional sales manager for New York Life, excitedly broke the news at a staff meeting in Springfield, Missouri.  A new law had been legislated that would allow workers with no employer-sponsored retirement plan to set up their own Individual Retirement Accounts (IRAs).

Apparently anyone earning a salary would be able to contribute up to $2,000 in untaxed dollars, which meant an immediate tax savings benefit.  As the lowest tax bracket at the time was 14%, a $2,000 IRA contribution meant an immediate $280 savings in taxes for anyone in that bracket. 

The rub was that withdrawals at retirement would be included in gross income subject to federal income tax rates, though insurance companies and investment advisors were quick to suggest that retirees would be in lower tax brackets by age 65.  Although earnings on IRA accounts were sheltered, IRA contributions and earnings would be taxed as ordinary income once withdrawn.  Further, withdrawals before age 59 1/2 would be subject to 10% penalty (certain exceptions apply under current law); otherwise they were mandatory starting by April 1 in the year after you become age 70 1/2.

Inevitably, some financial planners figured out that $2,000 contributed annually starting at age 21 for only the first six years ($12,000) at 12% compounded interest and would grow to over a million dollars by retirement. Hershey was excited because the insurance industry would be the primary beneficiary of this new investment vehicle.

However, since workers with pensions were not allowed to set up an IRA, the Carter Administration extended availability to all workers.  But when Congress realized that higher-income more than lower-income workers were taking more advantage of IRA tax advantages, the legislators responded in the Tax Reform Act of 1986 by limiting tax deferability to workers without an employer-sponsored pension plan or to those whose income levels were lower.

The Roth IRA was a knee-jerk reaction to the unpopularity of those 1986 restrictions. Enacted as part of The Taxpayer Relief Act of 1997, the Roth IRA removed the restrictions and created a reverse retirement vehicle. Contributions would not be tax deductible. But the same contributions withdrawn at retirement would also not be included in taxable income.  Also, they could be left invested for future generations rather than subjected to mandatory withdrawals.  Otherwise, like the traditional IRA, Roth IRA earnings accrue tax free.

A Roth IRA is mainly a savings vehicle. It can be set up within any IRS approved institution such as banks, credit unions, brokerage houses, etc., at any time during the year. But it must be funded before the owners tax filing deadline.  For 2011 the maximum contribution limits are $5,000 per person ($6,000 if over 50), based on qualified income. Spouses with compensation included in gross income also qualify for these same contribution limits. But such compensation must be at least equal to the contribution limit.

Qualified income includes wages and salaries, self-employment income, alimony, commissions, and non-taxable combat pay.  It does not include earnings from properties, interest or dividend income, pension or annuity income, deferred compensation, or income from certain partnerships. Nor does it include amounts excluded by the foreign earned income or housing exclusion (which are added to adjusted gross income for MAGI purposes). 

Contribution amounts for anyone with a retirement plan at work may be phased out as modified adjusted gross income (MAGI) levels rise according to filing status. In 2011, Single filers with a retirement plan at work are phased out from $56,000 - $66,000 of MAGI, Married filers from $90,000 - $110,000, and Married Separate filers between $0 and $10,000.

So if you are married filing jointly and your foreign earnings in 2011 were $97,000, your allowable funding for a Roth IRA would be seemingly be $4,100 ($97,000 92,900). But in actuality the amount allowable is only 3,900 ($110,000 97,000 x 30%); bearing in mind in this example that MAGI would be $97,000 if no other items of income.  But you cannot reduce FEIE below your foreign earnings to qualify your income for a fuller Roth contribution. Perversely you cannot opt to take FEIE in favor of taking 100% of the foreign tax credit.  On other hand, if you have no retirement plan at work, the MAGI thresholds are irrelevant to reducing your Roth contribution.

FEIE depends on foreign residence: bona fide or physical presence. In either case, the taxpayer must first qualify before any FEIE is available.  Once qualified as a foreign resident, the $92,900 exclusion can be lowered in the second year if you return to the U.S.  Suppose date of return 1 July 2011.  The exclusion amount would be reduced by 50%, with foreign income over $46,450 qualifying for Roth purposes. But subsequently the tax filer would have to re-qualify for the exclusion under the bona fide or physical presence tests.

During the qualification or re-qualification period, the physical presence test allows any 330 day period in a 12-month period. So suppose you are physically present in France, except for a 15 day vacation in December to the states, from 1 June 2010 through 30 September 2011 during which you earn $88,000.  To calculate the exclusion, count 330 full days backward from 30 September. Not counting the vacation days, 330 days is 21 October 2010.   Twelve months from this date is 20 October 2011, the last day of the 12-month period. The number of days from 1 January through 20 October 2011 is 293. The maximum exclusion is $74,570 (293 / 365 x 92,900). The bona fide presence test is met by residing in a foreign country or countries for a full tax year.  

(Revised April 2012)

Barron Harper of TaxBarron.com

Last Updated October 1, 2013