How To Reduce Your Tax Burden Living And Investing Overseas
Today is tax day in the United States. Too late to do anything about your 2012 taxes other than to file a last-minute extension if you need to. Meantime, you can (and should) begin to think about ways to mitigate and manage your tax burden going forward.
To that end, you may be wondering: Is it possible to reduce your U.S. tax bill by going offshore?
It depends who you are and, most important, where your money comes from.
The one and only true option for an American to eliminate his or her U.S. tax burden is to work overseas earning no more than US$97,600. Do that and you can avail of the foreign earned income exclusion (FEIE, which is US$97,600 for 2013). You have to qualify for the FEIE. You do this by being a bona-fide resident of another country or by spending 330 days or more in another country. Remember, though, that, depending on where you live and how your situation is structured, you could be liable for income taxes in the country where you’re living and working.
Obviously, this doesn’t work for everyone. Not everyone is looking to move overseas and get a job…and, even if that’s your goal, the truth is, it’s not easy to get a job in a country where you don’t hold a passport.
The bigger tax advantage for you as an American going offshore is to take your business offshore with you. In this case, you can work for yourself, thereby qualifying for the foreign earned income exclusion. Structure things properly, and you can also defer taxes on the profits from your offshore corporation until you pay those profits out in the form of salary or dividends.
This tax deferral is, in fact, similar to contributing to an IRA or 401k except that instead of handing your money over to an anonymous money manager, you’re reinvesting in your own business. Note, though, that, as U.S. person running your own business offshore, you still could contribute to an IRA or 401k, taking advantage of those tax-deferral strategies, as well, if you’d like.
IRA contributions are limited if you earn a certain level of income. 401k contributions are limited, too, but these can total up to US$67,000 (US$17,000 personally and US$50,000 from the business). Taking those tax deferrals along with your foreign earned income exclusion means you could move up to US$165,000 out of the business tax-free or tax-deferred annually. Then you can leave whatever profits the business earns beyond those levels in the business…again, deferring any potential U.S. tax.
Meantime, you could take your IRA and your 401k funds offshore if you want. To be able to take your IRA funds offshore, you simply need a custodian who allows for offshore investments. The IRS rules for IRAs limit investments that would qualify as “self-dealing.” They do not, however, limit the types or locations of most of your investments (other than collectibles).
Mainstream custodians such as Schwab and Fidelity don’t allow you to make offshore investments with IRA funds they’re managing for you simply because they only make money when you invest in stocks, bonds, or mutual funds. They aren’t set up to administer investments in real estate (foreign or U.S., both of which, again, the IRS does allow). That’s why you need a custodian who does allow these kinds of “alternative” investments (Midland IRA is one such custodian).
The easiest way to manage your offshore investments in your IRA is to set up an offshore LLC in which your IRA invests. Then you, as the managing member of the LLC, can direct the investments from there. As far as the custodian is concerned, your IRA is invested in the LLC. That’s all the custodian knows and that’s all the custodian needs to know. This structure keeps your custodian fees low and allows you greater flexibility and control.
You can invest 401k funds in offshore investments, as well, and, in this case, you don’t even need a special custodian. With a solo 401k, you can act as the plan trustee. The main difference between investing IRA funds offshore and investing 401k funds offshore is the tax form filing requirements. With an IRA, your custodian handles all the tax form filings. With a 401k, you have to file the forms (Form 5500 or 5500-EZ).
In both cases, it’s important to be aware of the investment constraints. Again, no self-dealing or dealing with immediate family is the biggest no-no. Your IRA cannot buy a piece of investment real estate from you personally, for example. Your IRA also can’t lend you money. It can, however, lend money to a third party.
As I said, too late to take advantage of any of these strategies on your 2012 tax return due today. But today is also the day to begin taking action so you can benefit from these opportunities starting with your 2013 tax return and beyond.
P.S. The real estate investor overseas enjoys additional tax advantages, both in the United States (if he’s an American) and, sometimes, in the country where he invests, too. These are covered in detail in my wife Kathleen Peddicord’s new book, “How To Buy Real Estate Overseas,” released last week and available online here.
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