This paper was authored by Rick Waechter, Old Peak’s founder. Rick was an expat in Hong Kong for 15 unforgettable years.

Summary

Living overseas can be an incredible experience. The rewards can be tremendous – experiences, friendships, travel and learning. For many expats, they can also be high earning years. But how do you make sure you will be financially prepared for retirement?
Everyone’s situation is unique, but there are many common issues. Our general recommendations:

• Make a financial plan that considers your goals, investing, estate planning, tax and related topics.
• Use a US brokerage account and US investment products – preferably mutual funds or ETFs. You reduce tax and simplify reporting and tax prep.
• Use a local bank for your daily banking needs, as long as it offers the convenience and safeguards of a large US bank.
• For daily expenses, own that currency. For longer-term goals, own the currency of those goals. When in doubt – and there is always some doubt – diversify.
• For mixed-nationality families, take advantage of the non-citizen spouse’s status to reduce income and estate tax.
• Get help from an expert. The cost of getting it wrong is high, and becoming more severe with new US regulations.

Making a Financial Plan

Everyone – not just expats – needs a financial plan. It should address six broad issues, encompassing your entire financial life:

1. Financial goal planning: Prioritizing your goals (retirement, college for your children, second homes, etc.) and creating a savings plan to afford them
2. Investments: Building and managing a diversified mix of investments, aligned with your goals and risk profile
3. Tax: Minimizing your projected lifetime tax expense
4. Insurance: Buying appropriate protection against risks such as premature death, disability, personal liability, auto and home loss, etc.
5. Estate planning: Dictating what will happen to your assets and loved ones when you are deceased, and providing instructions to others if you are incapacitated
6. Liability management: Determining appropriate use of debt

Investments

You should keep your investments with a US financial institution. By investing through a US financial institution, you can reduce fees, taxes and burdensome reporting. You can also benefit from a broad range of investment choices.

• Low fees: Most individual investors should buy mutual funds or exchange-traded funds (“ETFs”), which are essentially identical. The reason: diversification. The fees on US-registered mutual funds are far lower than the fees on so-called “off-shore” mutual funds – funds not registered in the US. Morningstar’s most recent survey rated the US as the #1 lowest-cost country for investing, whether in stock mutual funds, bond mutual funds or mixed (stock/bond) funds. Other surveys have reached similar conclusions. (1)
• Broad choice: Just because you invest in US mutual funds does not mean you invest only in US companies. US funds offer the broadest range of choice in the world. You can own funds that invest in the stock of US and non-US companies, in bonds issued by US and non-US companies, and in a variety of other investments such as real estate, commodities and more exotic products.
• Lower tax: US citizens will owe tax on any investments they make. But the tax on US-registered investments is typically much lower than that on non-US registered investments. Most off-shore funds are classified by the US IRS as “passive foreign investment companies”, or PFICs. The tax due on a PFIC is much higher than on US mutual funds. The IRS wants to discourage US citizens from investing in a PFIC, and the tax rates are a great incentive to avoid owning a PFIC.
• Less burdensome reporting: US brokers will provide the tax documents you need after year-end, listing dividend and interest income and capital gain in a format designed for your US tax filing. Non-US brokers typically will not; you have to make your own calculations. By having an account overseas, you will have additional filings with your tax returns: the Report of Foreign Bank and Financial Accounts (“FBAR”) and Form 8938 (“Statement of Specified Foreign Financial Assets”).
• Additional costs and fees: Non-US accounts create far more work for your CPA at tax time. The best example: The IRS estimates it takes 30 hours to record-keep, learn about and fill out a Form 8621, the tax form required for a non-US mutual fund. An even greater potential burden is the IRS penalty for not reporting foreign financial accounts, which can be thousands of dollars even for non-willful violations – and a lot more for willful violations.

Banking

By contrast, it usually is best to bank with a local bank, assuming it is strong, offers deposit insurance similar to that from US banks, and offers basic services like ATM access.
The advantages include convenience and keeping your spending money in the same currency as your expenses (and, presumably, your salary). The key disadvantage: you will have to file a Report of Foreign Bank and Financial Accounts (“FBAR”) and, likely, a Form 8621.

Tax and Passive Foreign Investment Companies (“PFICs”)

The US tax system is unique by taxing its citizens on their worldwide income even if they are not resident in the US. There are tax treaties with many countries which can reduce or largely eliminate US tax by crediting tax paid in your country of residence. If a US citizen living overseas invests in US-registered funds, he pays the same tax as he would if living in the US.

That includes capital gains tax on realized gains and on qualified dividend income and ordinary income tax (higher rates) on non-qualified dividends and on interest.

US citizens will pay much higher tax on a fund that is not US-registered, such as an “off-shore mutual fund” or non-US hedge fund. These funds are almost always classified as a Passive Foreign Investment Company (“PFIC”). The tax:

• All income and gains are taxed at the highest marginal tax rate (currently 39.6%). That compares to 15-20% long-term capital gains tax for a US-registered fund.
• Gain is assumed to be made pro-rata throughout the life of the investment, and tax is due annually. So, if you own the investment for five years and then sell, you will owe not just the 39.6% tax on the gain, but also interest for not paying the capital gains tax in the years it was “earned”. You can pay that on an annual basis, but you would be doing so without the cash generated from the sale.

The bottom line: owning a PFIC triggers such a high tax burden that it is unlikely the returns could justify buying it instead of a US-registered fund.

Mixed-nationality Families

Families with only one spouse who is a US citizen can adopt strategies to reduce US tax and to make reporting easier. But their situations can be complex, and the right answer is often to get advice from an experienced attorney or CPA.

The opportunities and complexity are caused by the following basic distinctions in US taxation:

• US persons owe US income tax on their worldwide income.
• US persons also owe gift and estate tax on their worldwide assets.
• Non-US citizens owe US income tax only on their US source income.
• Non-US citizens owe gift and estate tax only on US “situs” assets.

How can a mixed-nationality couple use these distinctions to minimize their US tax obligations – and to reduce reporting obligations?

Here are examples of strategies that often can achieve these goals:

• If the non-US citizen spouse (we’ll call him/her the Non-Resident Alien spouse, or NRA) has significant income, the US spouse can file US income tax as “married filing separately”, to avoid tax on any of the NRA’s income. The US spouse loses some deductions, but that can be a small price to pay compared to the tax savings for the NRA.
• Shares of US companies and US-registered mutual funds are best owned by the US spouse. There are two reasons:
  • Of greatest importance, the assets will be “US situs” assets and subject to US estate tax when the NRA spouse passes away.
  • The NRA spouse will owe withholding tax on current income, generally at a 30% rate. Admittedly, this may not be a big concern if an investor primarily seeks long-term capital appreciation. Capital gain does not attract tax for the NRA.
• Investment accounts owned by the NRA should typically be kept outside the US. This will avoid them being subject to US estate tax.
• To reduce US estate tax, the US spouse can gift up to $148,000 annually to the NRA spouse. This reduces the US spouse’s taxable estate. Note that, if both were US citizens, they could give unlimited amounts to each other. But if the US spouse passes away first, he/she can only give to the surviving spouse $5.45 million free of the 40% federal US estate tax. (2) (3)
• To reduce US estate tax, the NRA spouse should minimize US situs assets. Total US assets above $60,000 owned by an NRA attract estate tax.
• Consider a Qualified Domestic Trust (“QDOT”). A QDOT is a trust that postpones estate tax due at the US citizen’s passing until after the non-US spouse dies, and gives the NRA spouse the ability to access earnings and sometimes principal in the trust for living expenses. There are strict requirements in establishing a QDOT, and setting one up requires legal advice. But it allows the NRA access to money that could otherwise be subject to estate tax.

US retirement accounts: IRAs and 401(k)

What should you do with an IRA or 401(k) in the US if you are living overseas? The short answer: if possible, nothing. The US tax code allows taxpayers to defer income for years or decades by saving in an “individual retirement account” (“IRA”) or an employer-sponsored defined contribution plan like a 401(k). The optimal strategy: keep them in the existing account and let them continue to grow, tax-deferred, until you are in retirement. Deferring withdrawals until you are 70½ -- when you must, by law, begin to take taxable withdrawals – maximizes the tax benefit.

If a former employer requires you to take money out of your 401(k), try to roll it into an IRA. That will require you to find a US brokerage company which allows you to have an account with a non-US address. Depending on your domicile, you should be able to find a brokerage. Admittedly, it varies by country and brokerage firm, so you may have to do some research.
If you must take the money out, you will pay tax at ordinary rates on the entire amount and – if you are under 59½ -- a 10% penalty. Worse, it’s likely you are in a higher tax bracket than you will be during retirement.

One other caution: if the tax authority in your country of residence taxes earnings on off-shore accounts, earnings in your IRA or 401(k) could theoretically be taxable in that country, even though they are tax-deferred in the US. But that’s not common, so you need to research the tax regulations. Likewise, if you participate in a non-US tax deferral plan, it is likely still taxable in the US, losing much of the benefit.

FATCA

The Foreign Account Tax Compliance Act (“FATCA”) was passed in 2010 by the US Congress. FATCA requires foreign financial institutions such as banks and brokerage companies to provide information to the US government on any assets owned by a “US person” (US citizens, resident aliens, partnerships, corporations, estates and many trusts). This information includes names, addresses and tax ID numbers of account owners and account balances. The penalties for non-compliance by foreign financial firms are severe. As a result, they have only two realistic options: compliance or terminating relationships with all US person clients.

What are FBAR and Form 8938?

A “US person” with a financial account outside the US must file a Report of Foreign Bank and Financial Accounts (“FBAR”) if his/her total foreign accounts had a value over $10,000 at any time during the previous calendar year. The form, also known as FinCEN Form 114, is due June 30 for tax year 2015 and, effective for the 2016 tax year, on April 15 (with a 6-month extension available from April 15). The form is relatively easy to file and is submitted online, separate from your annual tax return. This is an informational filing; no tax is due. “US persons” includes citizens, resident aliens, trusts, estates and domestic entities.

Form 8938 (“Statement of Specified Foreign Financial Assets”) must be filed with your tax return if you had $50,000, in total, in foreign accounts on the last day of the tax year, or $75,000 at any time during the year. (These thresholds are higher if you live overseas or, for your tax return, are married filing jointly. For example, for a married couple living overseas and filing jointly, the thresholds are $400,000 and $600,000.) US citizens, resident aliens and certain non-resident aliens are subject.

Currencies

For living expenses, own the currency of the expenses – presumably the currency of your current residence. That explains the logic of keeping your money in a bank with a local office and local currency deposits.
For retirement or college savings, base your currency mix on where you expect to live when retired or where your children are likely to attend university. If you will retire in Thailand, you should build up some savings in Thai Baht, to protect you in the event the Baht strengthens significantly before you retire.

But we always recommend diversification. You can do that, most easily, by owning stocks and bonds from companies around the world or by owning the actual currencies in bank deposits. For example, if you own a US-registered mutual fund that invests in European countries, the value of your investment will rise and fall, in part, as the Euro and other local currencies rise and fall.

1. Morningstar Research, Global Fund Investor Experience, 2013 Report.
2. 2016 limit, subject to periodic increases with inflation.
3. 2016 limit, subject to periodic increases with inflation

This article is not intended to provide tax, legal, accounting, financial, or professional advice. Readers should seek advice from qualified professionals who can review their specific circumstances. Old Peak Finance endeavors to provide information that is accurate and current. However, we cannot guarantee that this information has not been outdated or otherwise rendered incorrect by new research, legislation, or other changes. Old Peak Finance has no liability or responsibility to any individual or entity with respect to losses or damages caused or alleged to be caused, directly or indirectly, by the information contained on this website.