Tag Archive for: Investments

Puerto Rico Tax deal
Christian Reeves

Puerto Rico Tax Deals for Corporations

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Thinking about moving your business offshore? If you are a US citizen, and your profits exceed $400,000, I guarantee Puerto Rico has a better deal for you.

As I reported last month, a US citizen can move to Puerto Rico and pay zero capital gains tax on his or her passive income and investments. That’s right, no US Federal or State tax on capital gains tax from real estate, stocks, and/or other investments acquired after you move to and become a resident of Puerto Rico.

This time around, I am here to tell you that Puerto Rico has a deal for business owners and entrepreneurs…a deal you can’t find anywhere else in the world unless you turn in your US passport.

Puerto Rico is offering business owners a tax contract similar to the one Switzerland and Russia negotiates with high net worth Europeans. Yes, Snowden’s Russia is a tax haven. For example, the actor Gérard Depardieu, angry over a plan by the French government to raise taxes to 75 percent for the wealthy, accepted a Russian passport from President Vladimir V. Putin. Russia has a flat tax rate of 13 percent.

A tax contract with Puerto Rico will allow you to cut your total (worldwide) tax rate down to 10% or lower without the need for any complex planning or structuring. Once you enter in to a contract, it can’t be modified or revoked by the government until 2036. Of course, you can leave Puerto Rico, thereby opting out of the tax deal, at any time. You can also spend a few months a year in the United States.

To receive these benefits, you are required to move yourself and your business to Puerto Rico, spend at least 183 days a year on the island, become a legal resident of this territory, and enter in to a tax contract with the government. Once you have relocated, you have opted out of the US Federal and State tax systems and in to the Puerto Rico tax code…which trumps the Federal code.

  • As a US territory, Puerto Rico’s tax code takes precedent over the US Federal tax code. While US Expats are bound by Federal tax law, American’s in Puerto Rico need only follow local tax rules.

Such a contract is the inverse of the Foreign Earned Income Exclusion (FEIE) and allows you to pay all of your taxes now at a reduced rate without the need to lock earnings in to an offshore corporation, captive insurance company, or some other complex tax deferral mechanism.

Let me explain: If you qualify for the FEIE you can earn up to $97,600 in salary free of Federal income tax in 2013. If a husband and wife are both working in the business, they might take out $195,200 combined. That is a major tax break which allows a properly structured offshore business earning $195,200 to be completely free of US tax.

Well, what if your business earns significantly more than the FEIE amount? You can usually retain excess profits in to your corporation and thereby defer US tax until you distribute these profits as a dividend. Capital gains, interest income and other returns derived from these retained earnings are taxable (may not be deferred) and dividends are taxed as ordinary income.

While the FEIE works great for those with business profits near the exclusion amount, it is not so wonderful for those earning significantly more. If you net $1 million a year and want to take that money as income now, then you are stuck paying US tax on the amount over the FEIE at 39.6% in 2013. This comes to about $318,000 in Federal income tax assuming a husband and wife both qualified for the FEIE and no State tax is due (($1m – $195,000) x .396) = $318,000. If only one person qualifies for the FEIE, your tax bill will be about $357,350 (($1m – $97,600) x .396) = $357,350.

In Puerto Rico, you pay income tax on the first $250,000 (using a graduated rate of up to 33%) and 4% on income over $250,000. There is no need to retain earnings in an offshore corporation and no issues related to tax deferral. You are paying tax each year as the money is earned…at a lower rate compared to those of us in the States, but no deferral or retainer earnings to worry about.

For example, on $1 million of business profits, your tax bill in Puerto Rico will be about $105,000, significantly less than the same US owned business operating offshore using the FEIE. This equates to an effective tax rate of about 10% ((.30 x 250,000) + (.04 x 750,000)) = $105,000 or 10%.

As your net profits increase, the benefit of Puerto Rico’s tax system increase and your effective tax rate drops. For example, on net profits of $3 million, your tax is approximately $185,000, for an effective tax rate of 6.2% ((.30 x 250,000) + (.04 x 2,750,000)) = $185,000 or 6.2%.

As stated above, if your net profit is anywhere near the FEIE amount, then living and working abroad and operating through a foreign corporation will give you the best tax deal. If your profits are between $100,000 and $500,000, then you might need to run the numbers to determine whether Puerto Rico or the FEIE provides the better option. Such an analysis would take in to account how much you are willing to retain in to an offshore corporation, how long you can lock those profits away, and the deductions you have available on your US personal income tax return (itemized deductions such as mortgage interest, property tax, charitable contributions, etc.). I have not considered these issues in the examples provided.

What about those of us earning less than $1 million from our business? In Puerto Rico, you will be required to take salary of 1/3 of your net profits, up to a maximum salary of $250,000, and pay 4% on the remaining 2/3. So, if you earn $300,000 in total profits, your tax would be about $38,000 or 12.6% ((.3 x $100,000) + (.04 x $200,000)) = $38,000 or 12.6%.

If that same $300,000 was earned as salary by a US citizen using the FEIE and an offshore corporation, the first $97,600 would be tax free and the remaining $202,400 would be taxed at around 31% in 2013. This means your US Federal income tax will be about $62,644 (($300,000 – $97,600) x .31) = $62,644 for an effective rate of about 20%.

If a husband and wife are both working in that business with a net of $300,000, the FEIE amount becomes $195,200, and the balance is taxed at approximately 29%, for a total tax of $30,392. Therefore, at this income level it will be more efficient for a single person to operate in Puerto Rico and a married couple to be based offshore (($300,000 – $195,200) x .29) = $30,392 or about 10%.

When you combine these business tax incentives with the personal tax benefits of zero capital gains, you have a very strong contender in Puerto Rico. It is a deal that no country in the world can offer a US citizen.

So, why is Puerto Rico doing this? This island territory is in its 8th year of recession and is desperate to attract some wealth and prosperity. 4% tax on business profits is better than no business and no tax revenues.

How bad is the economy? Puerto Rican bonds are sold in the US with yield above 10%, which is extremely high. So high that Puerto Rico was forced to cut its offering this week the island’s Government Development Bank announced it would cut bond sales to between $500 million and $1.2 billion for the rest of the year. This yield compares to California municipal bonds at a current high of 3.13%, up from 2.17% at the end of 2012.

As the territory struggles with $70 billion in public debt and a 13.9% unemployment rate, higher than any U.S. state, it is searching for new ways to bring in capital, employment and investment. The government hopes to cut its $820 million budget deficit in half by 2015.

But, there is hope for Puerto Rico. While the US is completely out of control, Puerto Rico’s deficit has been reduced from $2.4 billion over the last couple of years. The island’s five-year economic plan calls for creating more than 90,000 jobs that would add as much as $7 billion to the economy by 2016, and another 130,000 jobs and as much as $12 billion of growth by 2018.

While these tough economic times might prevent a firm from building a large factory, or committing millions to the Island, they should not deter a high net-worth investor and business owner from picking up and moving. These tax incentives are guaranteed by the government until 2036 and can’t be withdrawn or amended. Even a law change would have no affect because your earnings are not locked in to the corporation, as they are with retained earnings in excess of the FEIE.

For more information, here are some links to other sites.

Links to Outside Resources

If you are considering moving your business  to Puerto Rico or abroad, please contact me for a confidential consultation. You can reach me directly at info@premieroffshore.com or (619) 483-1708.

Puerto Rico Pic
Christian Reeves

Move to Puerto Rico and Pay Zero Capital Gains Tax

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Are you tired of paying in to the Obamanation? Is most of your income from capital gains taxed at 24% plus whatever your State grabs? You can eliminate tax on interest, dividends and capital gains by moving to Puerto Rico…immediately and legally.

Those of you who have been following me on  Live and Invest Overseas and PremierOffshore.com for a while know I am focused on showing business owners how they can move their operations offshore to eliminate or defer US tax using the Foreign Earned Income Exclusion. While this model works great for the entrepreneur or small business owner, it provides little benefit for retirees or those who make a living trading stocks and investing.

While the US is taxing and redistributing wealth as quick as it can, Puerto Rico has seized upon this opportunity (an Obamatunity if you will) to entice high net worth individuals to move to their happy islands. Puerto Rico has completely eliminated tax on capital gains, interest and dividends. Yes, that’s right, once you become a resident of PR, you can legally pay zero capital gains tax. No more Federal tax, no complex planning, and no fear of the US government finding your offshore account.

I am not talking about only cutting out your State tax…I am saying you can jettison ALL United States tax on interest, dividends, and capital gains. This is possible because Puerto Rico, while a commonwealth of the United States, is treated as separate for tax purposes. By moving to PR, you can opt out of the Federal tax system and in to the PR tax program. This is because, under the Internal Revenue Code (IRC), capital gains are sourced to your place of residence and the IRC has one section detailing Federal law and another specifying laws of the territories.

Retired? Puerto Rico does not tax social security or unemployment income.

I would like to note here that moving to a foreign country with a low capital gains tax rate does not reduce your effective tax rate on passive investments. This can only be accomplished by relocating to a tax friendly US territory. As a US citizen, you are taxed by the US IRC on your worldwide income no matter where you live. When you move abroad, you remain under the jurisdiction of the Federal Government. So, if your country of residence taxes your gains at 5%, and the US at 20%, then you pay 5% to your country and 15% to Uncle Sam for the right to carry his passport. But, when you move to Puerto Rico, you fall under a unique section of the US tax code for the Commonwealth which trumps Federal law. You are opting out of the IRC Federal system and opting in to the IRC commonwealth system.

In other words, once a U.S. citizen becomes a resident of Puerto Rico, any income derived by that person from sources within Puerto Rico is excluded from U.S. Federal income tax, and taxed under the Puerto Rican income tax code. However, any income derived from outside of PR remains taxed under the Federal law.

So, capital assets (such as land, stocks, bonds, etc.) acquired after moving to PR are tax free. As for property acquired prior to becoming a resident, special provisions can result in a 10% long term rate from the day you qualify and a 5% tax rate applies to property acquired prior to becoming a resident and held for at least 10 years thereafter. See details below.

Why is Puerto Rico Doing This?

While I could pontificate on how PR sees the error of our ways and is a bastion of freedom and capitalism, the truth is probably less grandiose. Puerto Rico’s per-capita income is around $15,200, half that of Mississippi, the poorest state in the nation. Puerto Rico has been battered by several years of recession and its unemployment rate is over 13 percent, well above the national rate, and its economy remains in a funk. Moody’s Investors Services rates the island’s debt one notch above junk status; and in a recent research note, Breckenridge Capital Advisors said the island was “flirting with insolvency.” The island has the weakest pension fund in America and by some estimates could run out of money as soon as 2014.

I also note that these tax breaks apply only to new residents and not those currently living in Puerto Rico. More specifically, they are available to individuals who have not been residents of Puerto Rico within in the last 15 years and who become residents of Puerto Rico on or before December 31, 2035. As such, PR is obviously attempting to bring in new money to revitalize their fledgling economy.

Qualifications

To qualify, you must become a tax resident of Puerto Rico, reside in PR for at least 183 days a year, and file an application for the exemption with the local tax authority. Once approved, the decree establishes the terms of the exemption and has the effect and force of a contract during the entire benefit period. Considering the weakness of the PR economy, and how frequently tax laws change, this contract status is a major benefit.

Incentives

The tax incentives available to individuals are as follows:

  • 100% tax exemption on interest and dividend income earned after the nonresident individual becomes a resident of Puerto Rico; also applies with respect to alternative minimum tax (AMT) up to tax year 2036
  • 100% tax exemption on interest, financial charges, dividends or distributive share on partnership income from international banking entities in Puerto Rico including AMT
  • 100% tax exemption on long-term capital gains realized and recognized after becoming a resident of Puerto Rico but before January 1, 2036
  • If not realized and recognized within the incentive timeframe, regular individual long-term capital gain applies (currently at 10%)
  • Applies to appreciation of property after becoming a resident of Puerto Rico
  • 5% tax on long-term capital gains realized before becoming a resident of Puerto Rico, but recognized after 10 years of becoming a resident of Puerto Rico, as long as recognized before January 1, 2036
  • This 5% long-term capital gain tax only applies to the portion of gain that relates to the appreciation of the property while the individual lived outside Puerto Rico
  • If the long-term capital gain is not recognized within these time periods, applicable individual long-term capital gain rate would apply on any Puerto Rico-source long-term capital gain

Puerto Rico also has great incentives for business owners, based around the tax breaks on dividend payments, which I will detail in a future article. If you are considering living and working abroad, give Puerto Rico a chance. Because of its status as a US territory, these islands can offer tax incentives to US citizens that are not available anywhere else in the world.

Long Term Capital Gains Rates
Christian Reeves

U.S. Long Term Capital Gains Rate up to 23.8%

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Most of you know that the U.S. long term capital gains rate went up from 15% to 20% for high income individuals. I’ll bet quite a few will be surprised by an additional increase of 3.8% on just about all types of investment income for “wealthy” Americans.

Effective January 1, 2013, the Obamanation tax increase imposed a new levy on net investment income of 3.8%, which is to be used to shore up our failing Medicare system. This surtax generally applies to investment profits of individuals, estates and trusts with incomes above the statutory threshold. This threshold amount for a single taxpayer is $200,000, and $250,000 in the case of married couples filing joint. The threshold amount for estates and trusts is a mere $11,950 for 2013.

The thresholds for the Medicare surtax are imposed independent of the $450,000 and $400,000 thresholds under the American Taxpayer Relief Act of 2012 that set these as the starting points for a 20% long term capital gains tax rate. These taxes are paid with your personal tax return, Form 1040.

The Medicare surtax defines net investment income very broadly. It encompasses many types of income, such as interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer (partnerships and LLCs are passive investments unless you are involved in the day to day operations).

Here is how the long term capital gains rate and Medicare surtax work at their most basic level:

  • If you are in the 10% or 15% (low income) tax brackets, you will pay no capital gains tax.
  • If you exceed the 15% bracket, but earn less than $250,000 married filing joint, your long term capital gains tax rate is 15%. In other words, the 15% rate would continue to apply to taxpayers in the 25%, 28%, 33% and 35% income tax brackets.
  • If you earn more than $250,000, but less than $450,000 MFJ, your long term capital gains tax rate is 15% and your investment tax is 3.8%, for a blended rate of approximately 18.8%.
  • If you earn more than $450,000 MFJ, your long term capital gains tax rate is 20% and your investment tax is 3.8%, for a blended rate of approximately 23.8%.

For a more detailed analysis, see the Forbes blog or the Wall Street Journal.

For the American abroad, it is important to remember that you are required to pay U.S. tax on your worldwide income, which includes all passive and investment income. The only deduction available for passive income is the foreign tax credit, which should eliminate double taxation on investment income, but does not reduce your net tax below the U.S. rate.

Also, the Foreign Earned Income Exclusion does not affect your U.S. tax bracket, nor does it reduce your adjusted gross income amount, which is used in calculating your capital gains rate.

For example, if a husband and wife are living abroad, each qualifies for the FEIE, and each earns a salary of $96,000 for 2013, they will pay zero U.S. Federal Income tax on their salary. However, their adjusted gross income for determining capital gains rates will be $192,000, and their long term capital gains will be taxed at the blended 18.8% rate.

This also means that every dollar earned in excess of the FEIE is taxed at the 28% or 33% tax rate. Your tax rate does not start from zero after taking the FEIE consideration.

Please contact us at info@premieroffshore.com if you would like us to prepare your U.S. personal or business tax returns. We are experts in the tax laws applicable to American’s living and working abroad.

Christian Reeves

Taxation of Foreign Real Estate Investments

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EDITORS NOTE: This article was published in 2010 and has some valuable information. For a more recent and detailed article on this same site, click here.

 

When it comes to investing in property overseas, there is often little difference than if you were investing in U.S. property. Three situations bear investigation:

1. The first is the purchase of raw land or a building for speculation. In this scenario, the investor buys a property overseas and plans on holding it for a period of time to later sell for a profit. The result is a capital gain taxed by both the U.S. government and, in some cases, the state of domicile of the taxpayer. The U.S. has favorable tax rates (currently 15%) if the holding period is over one year. There may also be a capital gains tax in the country that the property is located in. If this is the case, a credit can be used to offset U.S. taxes.

In this situation, there is no difference in how the U.S. taxes the sale of an investment property in the U.S. and one outside of the U.S.

2. Let’s look at the same scenario, except this time, instead of selling the property outright you want to exchange it into another property. This can be accomplished by using the provisions of section 1031 of the IRS code. Under this section, you can defer some or all of the gain from the sale of one property by simultaneously purchasing another property of “like kind.” Here again, there is no difference in the taxation of property inside the U.S. and outside the U.S.

What we must look at in this situation is the exact definition of “like kind.” When dealing with real property, the government gives quite a bit of latitude in what is considered “like kind.” Examples are raw land, a single family house, a condo, an apartment building, a restraint, etc. As long as you’re selling real estate to buy real estate, you will generally be allowed to perform a 1031 exchange.

The main thing to be aware of is that foreign real property and U.S. real property is not considered to be like kind. For instance, you cannot exchange a rental property in California into a rental property in France or to raw land in Costa Rica (or vice versa).You could however exchange the rental property in France into raw land in Costa Rica. What this boils down to for you, the investor, is that, if you want to move an investment back into the U.S. you will have to pay taxes on any gains you made.

If a property qualifies as “like kind” then you must also qualify the exchange. There are complexities involved with this type of transaction, and you should hire a tax consultant to facilitate the transaction and make sure that you don’t do anything to disqualify the non-recognition of gain. Another critical point is that your new property needs to be more expensive and have a larger note on it. Otherwise a portion of the gain will be recognized and taxable. For more information, see the “Nontaxable Exchanges” section of IRS Publication 544 Sale or Other Dispositions of Assets available at www.irs.gov/pub/irs-pdf/p544.pdf.

3. The third consideration is when you have a rental property overseas. In this case, it is much the same as a rental situation within the U.S. The main consideration is that rental activities are considered passive. This means that losses from your passive rental activities can only offset income from other passive sources. If you do not have any other passive income, the losses are suspended until such time that you have passive income or you sell the property—at which time the losses are released and can offset other types of income.

An exception to this rule applies to active participants in the management of real property. As an “active participant,” you must share in the management decisions for the property, arranging for others to provide services like repairs, etc. Owning property in a foreign country makes it more difficult, but not impossible, to qualify as an active participant. If you meet this requirement, you can deduct the losses from your rental property against your other income (like wages, self-employment, interest, and dividends).

Besides the need to qualify as an active participant you must also meet these additional requirements:

  • You must own more than 10% of the property.
  • You cannot be a limited partner.
  • You must be an active participant in the year of the loss and the year that the loss is deducted. The benefit phases out at an adjusted gross income of between $100,000 and $150,000.

Finally, you will only be allowed straight line depreciation on property outside of the U.S. You are not eligible for the various accelerated depreciation methods.

Implications of Your “Tax Home”

If you only have one tax home regardless of whether you reside in the U.S. or overseas, there are few, if any, complications.

For people with multiple homes or multiple business ventures at which they spend varying amounts of time, it gets trickier. These situations are decided on a case-by-case basis, according to individual circumstances. Some of the facts that will be looked at are:

  • Total business time spent at the different locations.
  • The amount of business activity that is carried on at each location.
  • The significance of the business activity to the taxpayer’s return (where is more money made and what percentage of the total income does it represent?)

Let’s look at some examples of how the tax home concept can affect the taxes of the international real estate investor.

Example 1—Bob and Jane live in the United States and work close to their home. They own some real estate outside the U.S.

In this case, their tax home is their residence and all expenses they incur when visiting their realestate (whether rental property or investment property) are deductible against the income fromthat property.

Example 2—Bob and Jane live in the United States and work close to their home. They spend part of the year at their foreign property—a small house in France with a vineyard.

In this case, whether they can deduct all their living expenses (travel, meals, utilities, incidentals) as “away-from-home” expenses in pursuit of a business is dependent on the facts. Which home do they spend more time at? Where do they make more of their money? How much of their time at the foreign home is devoted to the vineyard business?

If it is determined that more time is spent at the foreign location, the deductions will not be allowed. This is exactly what happened in the case of Bowles v. United States. The taxpayers claimed away-from-home expenses for their grape-growing business, but the IRS and then the courts ruled that, since more of the couple’s time was spent at the vineyard, the vineyard was their tax home and the deductions weren’t allowed.

Example 3—Bob and Jane live in the United States and work close to their home. They own a seasonal B&B in Europe, which they spend the summer operating.

In this case, if Bob and Jane can prove that their tax home is in the United States, all of their living expenses can be deducted as away-from-home expenses (in any case the direct expenses of operating the business are allowed).

What is important to note is that you need to plan your actions beforehand. If you are going to operate a business, or own real estate overseas, and you want to deduct your overseas living expenses as away-from-home expenses, you need to make sure that you create a fact pattern consistent with a tax home in the U.S. Direct expenses of the business or investment are always deductible and are not dependent on where your tax home is.

Note: There is an important distinction in the concept of “tax home” for purposes of deducting away-from-home expenses and qualifying for the foreign earned income exclusion. Multiple homes may cause the loss of the away-from-home expenses but, as long as they are all overseas, you may still qualify for the earned income exclusion and the housing exclusion.

 

EDITORS NOTE: This article was published in 2010 and has some valuable information. For a more recent and detailed article on this same site, click here.

 

Offshore Shelf Company
Christian Reeves

The Real Costs of Your 401K Revealed

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401(k) Fees Revealed – Get Ready for a Shock!

If you have a 401(k) account with a U.S. broker, you are about to get the shock of your life. When you receive your next quarterly statement, probably between Sept. 30 and Nov. 15, do not open it without taking precautions!

I suggest you take the envelope over to the sofa and sit down, remove any sharp objects, or anything which could be thrown against the wall in anger, take a deep breath, and then open it. You are sure to find a whole host of fees and expenses that you have been paying all along and had no idea. You will now learn exactly why you have lost money, or why your returns were less than stellar, and how much of that was due to hidden fees charged by the broker who was working so diligently on your behalf.

Why the new disclosures? For the first time since Congress laid the groundwork enabling these plans in 1974, all of your fees must be disclosed. Previously, these statements showed investment returns after fees were deducted, but did not show the fees themselves — probably leading you to believe that your investments weren’t returning as much as they actually were.

Now, because of new government regulations, you’ll be able to see how your investments have done before fees are deducted because actual returns and costs will be displayed in separate columns. You will have a clear picture of how your investments did and how much was taken out for management, in transaction fees, etc.

Ok, you just found out that you have been grabbing your ankles for a very long time. What can you do with this information? If you have a 401(k) with your current employer, you may be out of luck. You can storm in to your HR department and demand that they find a firm with more reasonable fees. Enough of the local broker who buys dinner and drinks for HR guy! If they refuse, you have little recourse.

If you have a 401(k), or any other type of retirement account, with a former employer you can take over control, eliminate 90% of the fees, and make your own investment choices by moving it in to a Checkbook LLC. You simply form a U.S. LLC or international LLC and transfer the retirement account from your current provider in to that entity.

Note that the law requires your retirement account have a licensed agent involved. Thus, there will be a U.S. administrator and minor fees with the LLC. However, the administrator will not be involved in your investment decisions and he will not take a piece each time you make a trade. His primary role in the Checkbook LLC is to handle annual reporting to the IRS. You tell him how your investments did at the end of the year and he reports to the government.

You have two choices with the Checkbook LLC. You can use a U.S. LLC and make investments in the United States, or you can use an international LLC and make investments outside of the U.S. of A. With the international LLC, you can hold your funds in any bank or brokerage around the world, in any currency or currencies, and make any investment you see fit.

For example, the international LLC can invest in real estate in Ecuador, have a bank account in Belize, trade currency through a broker in New Zealand, and own gold and other precious metals in a vault in Switzerland. The investment options are unlimited, and the decisions are yours. You will not be required to get the permission of the administrator…you simply write the check (hence the name, Checkbook LLC) or send the wire to complete the transaction.

Of course, there are some basic rules. For example, you must manage the LLC for the benefit of the retirement account.

In other words, you must handle it as an investment account, and not take any money for personal use. You can purchase real estate as an investment, but you cannot live in the property…you must rent it out to an unrelated person at fair market rates.

If you would like checkbook control over your retirement accounts, please contact Premier Offshore Investor at (619) 483-1708, or email info@premieroffshore.com. We will send you a detailed presentation with all the rules, answer any questions, and guide you through the process.

Convert to ROTH
Christian Reeves

Expats – Convert to a Roth ASAP!

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If you qualify for the Foreign Earned Income Exclusion and have a traditional IRA, now is the time to convert that relic to a Roth. Doing so may save you a fortune in taxes, especially if completed in 2012.

The Foreign Earned Income Exclusion (FEIE) allows you, the intrepid Expat, to eliminate up to $95,100 of wage or ordinary income from your 2012 tax return. If you and your spouse are both operating a business, or are wage earners, you might exclude up to $190,200 combined.

To qualify, you must be living and working outside of the U.S. This means you are 1) employed by a corporation (it does not matter if you own that company) and 2) are a resident of a foreign country or are outside of the U.S. for 330 out of any 365 day period.

So, the FEIE takes care of your ordinary income. However, we Expat Americans are still required to pay U.S. tax on our investment and passive income, no matter the source. That means all of the benefits of a retirement account apply and the tax rate and rules for investment income are the same for Expats and residents.

For an Expat, a Roth IRA has numerous tax planning advantages over a traditional IRA. This is because you pay taxes on the front end while you are maximizing the FEIE and you don’t pay taxes when you withdraw funds in retirement. Also, there are no required minimum distributions when you hit retirement age.

A traditional IRA allows you to deduct contributions on your tax return and any earnings grow tax-deferred until you retire. But these deductions may be of little or no value to the Expat whose income is less than $95,000 or $190,000 joint. Also, because of significant capital gains and other passive income, an Expat’s tax rate may be higher in retirement than while working under the FEIE. In that case, converting to a Roth after retirement can be costly.

Converting to a Roth or contributing to a Roth while abroad will allow you to make the most of your itemized deductions. For example, all Americans may deduct mortgage interest (on up to two homes), property tax, medical, etc., or take the standard deduction of $5,800 single and $11,600 joint (tax year 2011). It does not matter if you maintain a home in the U.S. for your family and/or you have a home abroad, all citizens get the same deductions.

If all of your taxable income is being eliminated by the FEIE, you aren’t utilizing your standard deduction or your itemized deductions…you are already paying zero tax, so these deductions provide no added benefit. Converting to a Roth or investing in a Roth under these circumstances may save you tens of thousands of dollars each year.

Let’s run some numbers on the tax cost of converting to a Roth IRA.

One of my tax preparation clients has been living in Cayman Islands for a number of years. He earned a salary from his offshore company, which is incorporated in Panama, of $81,000 in 2012. All of his ordinary wage income is covered by the FEIE, so he pays zero U.S. taxes, and he has about $60,000 in a traditional IRA. His itemized deductions are about $34,000 for 2012, mostly the result of mortgage interest on his home in Cayman.

If this client were to convert his IRA to a Roth in 2012, his total tax bill on $60,000 would be only $2,300. This is because the Foreign Earned Income Exclusion eliminates his salary and he now gets to make use of his $34,000 in itemized deductions.

If this same client, who is married filing joint, had no itemized deductions or Schedule A and took the standard deduction, his IRS bill would be about $8,000.

Note: If this same client wanted to pay zero tax, he could convert some of his IRA to a Roth in 2012, and the balance in 2013 and/or 2014, thereby maximizing his itemized or standard deductions for each year.

If this Caymanian did not qualify for the FEIE, his U.S. tax bill on $81,000 would be about $4,200 (remember, he has significant itemized deductions). If he also converted his IRA to a Roth while paying tax on his salary, his bill would be $18,400. If he had no itemize deductions, his total tax bill, including the conversion, would be $20,500.

So, converting his IRA while qualifying for the FEIE, results in a savings of $16,100 ($18,400 – $2,300) for this client. Each person’s tax situation is different. You should contact a tax professional to determine your possible savings before deciding to convert your IRA to a Roth.

Considering the approaching “financial cliff,” it is safe to assume that U.S. tax rates will increase and deductions will decrease in 2013. Any change to the IRA rules, tax brackets or capital gains rates, may have a significant impact on your net tax due and IRA conversion options. If you qualify for the FEIE, converting from a traditional IRA to a Roth in 2012 rather than 2013 is likely to save some serious cash.

Converting to a Roth is as simple as contacting your provider and telling them you wish to convert. If you would like to move your IRA offshore, or need assistance with your 2012 Expat tax returns, please contact us at info@premieroffshore.com or (619) 483-1708.