401K and IRA for foreigners in the United States?

We have been busy with other things in life since more than a year ago and just responded to questions/comments sparingly. I (Yannick) didn’t expect to do another post for a long time but obviously changed my mind because of the excellent question from Abhishek: are there any strings attached to these retirement accounts for foreigners?

If a foreigner plans to stay in US until retirement, then the answer is a straight-forward “no extra string”. For tax purpose, Abhishek has been in the States long enough (6 years) to be treated as a Resident Alien, same as a US citizen. So same rules and penalty apply regarding distribution and early withdraw.

If on the other hand, Abhishek plans to return to his home country after a few years, the answer depends on the tax policy of his home country and the tax treaty (if there’s one) between that country and US. It may very well be less strings (or one more way out) for foreigners. The key questions are usually:
How does the foreigner’s home country treat retirement accounts in US? Is the investiment in a US 401K or Traditional IRA treated as tax deferred as well? Is the Roth IRA treated as tax-free? If not, there’s little reason to use them except contributing to the minimum level in a 401K to get employer match.

If the answers for above questions are yes, then you can have the option to leave the money grow tax-defered or tax-free in US until you reach retirement. US still has the most efficient captial market and lots of long term potenial. So this could be a good diversification investment strategy. Be sure to choose an institution/custodian which keep accounts open when you leave the country. I also recommend to roll-over 401K balances into an IRA accont before you leave. 

What if I need to leave US and also need the money before retirement? First, you want to file a W8BEN with your US custodian to avoid a automated 20% tax withholding at the time of withdraw.  To avoid 10% early withdraw penalty, you need to see if a tax treaty allows a trustee-to-trustee transfer of your money from a US account to a pension fund in your home country.  If not, you want to see if you are okay with annuitizing your traditional IRA money (roll-over 401K to traditional IRA first) or just withdraw your Roth contributions. A SmartMoney article  summarized this approach very well. This applies to all US residents.

If however, you want all of your money within a few years and your home country doesn’t double tax you for incomes in US, then maybe the best bet is to bite the bullet of 10% penalty, while managing the withdraw in each year low enough to avoid US income tax. Income tax is usually much higher than 10%, therefore you may be better off doing withdraw this way, which is not available for most folks staying in US all the time. 🙂

In summary, if you don’t know your long term plan yet, you are likely better off by contributing to 401K and Roth IRA as long as your home country doesn’t double tax you for income earned in US. Please check out our ranked list for savings to manage the trade-off between tax-advantage and liquidity. BEST OF LUCK to Abhishek and all you visitors!

Who can contribute to an IRA?

We are looking into the possibility of letting Jacqui stay at home as a housewife. However, we’re concerned that if it will impact our plan to catch up on retirement savings. So I studied IRS Publication 590, Individual Retirement Arrangements and found the following excerpts:

Traditional IRA:

  • You (or, if you file a joint return, your spouse) received taxable compensation during the year, and
  • You were not age 701/2 by the end of the year.

Roth IRA:
Generally, you can contribute to a Roth IRA if you have taxable compensation (defined later) and your modified AGI (defined later) is less than:

  • $160,000 ($166,000 for 2007) for married filing jointly or qualifying widow(er),
  • $10,000 for married filing separately and you lived with your spouse at any time during the year, and
  • $110,000 ($114,000 for 2007) for single, head of household, or married filing separately and you did not live with your spouse at any time during the year.

Besides the age restriction for traditional IRA and the income restriction for Roth IRA, a person need to have taxable compensation to contribute to an IRA. The taxable compensation includes salaries, tips, bonuses, commissions, self-employment income, alimony and separate maintenance, nontaxable combat pay but does not include passive income derived from property and investment (Table 1-1, Page 9). However, a non-working spouse (aka a housewife) can contribute to either IRA with the same maximums given the working spouse qualifies for the above criteria (Refer to spousal IRA in the above document).

So the good news is that if Jacqui stay at home, both of us will be able to contribute to IRA though it’s not necessarily Roth.

How much do we need for healthcare after retirement?

Healthy fully-employed young professionals may not pay much attention to healthcare cost. However, that will be an expensive part of retirement savings. Fidelity Investments have released its annual study for retiree healthcare cost for seven years. It is reported that “a 65-year-old couple retiring this year needing about $215,000 to cover medical costs after they stop working”. I remember some young people were arguing if 1 million dollars are enough in 30 years for retirement. This report certainly shed a light on the answer: you will need $521,861.43 in 30 years assuming healthcare cost increases at a historical annual inflation rate of 3%; $1,270,281.51 in 30 years if healthcare cost increases at an average of 6.1% annual rate as in the last seven years.

And the scary part is the conservative assumptions of Fidelity’s estimate. It’s not all healthcare cost.
1. It doesn’t include over-the-counter medications, most dental services and long-term care;
2. It assumes retirees have no employer-provided health care coverage;
3. It projects life expectancies of 82 for men and 85 for women.

People may wonder if we can get employer-provided health care coverage after retirement in 30 years. Let’s look at this trend identified by the same study: “between 1988 and 2006, the share of large employers offering retiree health benefits declined to 35 percent from 66 percent. Employers also have shifted more of the costs to retirees through higher premium contributions and higher cost-sharing requirements.” It does not look like that most of us can get it!

Fidelity actually has a breakdown of annual medical expenses.

Type of Expense Annual Cost Monthly Cost
Medicare A Premium $0 $0
Medicare A Deductible $231 $19
Medicare A Co-Pay $51 $4
Medicare A Skilled Care $77 $6
Medicare B Premium $1062 $89
Medicare B Deductible $83 $7
Medicare B Co-Pay $902 $75
Other misc. $293 $24
Dental/Vision/Hearing $388 $32
Medicare Supplement (Medigap) F2 $2,244 $187
Prescriptions (Medicare Part D)3 $1,300 $108
Total: $6,631 $551

Are you ready?

Where to put my savings, house, IRA, 401K or regular trading accounts?

When I finally earned more than what I spent, I asked myself this question. Due to the time I already squandered, there are so many places need my money badly:
Emergency fund and cash savings
Individual retirement accounts (IRA) such as Roth and traditional IRA
Employer sponsored retirement accounts 401k, 403b (non-profit organization and education institutions)
A house
A regular brokerage account to invest in the stock market

My order is the following:
1. Roth IRA
You may be surprised that I put to Roth before emergency fund. The reason was not only that Roth is one of the best places for young professionals and graduate students’ money, but also that you can withdraw your contributions (the money you put into such an account) any time without incurring any penalty or taxes. So your contributions can serve as your EF. It is so nice that no wonder you can only contribute $4000 a year.

2. 401k or 403b and a lull with employer matching
Many people have this on the top of their lists. The argument was simple, you can get free money. Many people contributed to their 401K and got those employer matchings. However, because they do not have enough liquid asset (contributions in Roth or emergency fund), they were forced to get the money out in case of urgent financial needs, which leads to taxes and penalty.

3. Emergency Fund
The contributions in Roth is not a perfect emergency fund, because you will not be able to put contributions back after withdraws, which leads to the loss of opportunity for tax-free earning growth. I have shared my experience in a recent post. The good news is that you do not need to constantly put new money there. After you find out how much to put in, and fund it, then you are mostly done. Also as Moomin Valley commented, after you accumulate more assets, you can get away without a real emergency fund since it’s very likely you’ll have very liquid assets because of asset diversification.

4. 401k or 403b remaining portion
You can decide for a self how much you want to put into your retirement account, because this portion is not liquid-able. However, if you want to invest in the stock market, the advantage of text deferment cannot be understated. As two late-starters, Jacqui and I are maximizing this part. Another late starter moom shared his experience.

5. Savings as in savings account, CD or regular brokerage:
You do want to enjoy your life before retirement also, right? However, I do not over-save for this part as I think my future income is good enough to cover my future expenses.

6. House:
We do not own a house yet and are saving for a down payment. Normally, it should be listed as 5. However, the more I learn about the housing market and the unprecedented housing boom, the more I realized that how over-valued the current housing market is. I guess it will be number 6 for the next two years at least.

What’s your list like?

Emergency fund? How much?

Moom started his Asset Allocation Series. So I guess it is not surprising for him to write about Emergency Fund (EF), and introduced us to English Major Money’s (EMM) post. This was also our first time to participate in Carnival with a post on getting more tax returns for international students. I happened to find a controversial post by “Broke Now, Rick Later” (BNRL) in the Carnival. So I will share my thoughts here.

First, no emergency fund needed? I have to say that I admire BNRL’s courage. For a single-income household with 2 kids and a mortgage to pay, he has extremely low liquidity of $282. And he was advocating NO emergency fund needed. Make no mistake, he is stacking away 20% of his income in retirement savings, which is unlikely to be ready available for emergency. So he is trading his emergency fund as extra investments in retirement account. Before reading his post, I thought there were few people as described in moom’s comment. Now I think that there might be quite a few.

BNRL has 50% income to cover monthly necessities and 20% for retirement account. Considering tax withholdings and other expenses, the remaining 30% is unlikely to have any significant portion left. BNRL argued that you can always count on 0% APR installment payment combined with a delay in payment to pull the cash you need from either your salary or disability income. However, he maybe forgot that sometimes, “when it rains, it pours”. What if there were two or three unexpected on his list on going at the same time?

Second, how much emergency fund do you need? I stand by the standard recommendation of 3-6 month expense and suggest everyone to look at his/her own situation like EMM did. The amount will depend on both your needs and your risk attitude.
Needs (expenses): take a look at the monthly necessary expense. For renters like Jacqui and I, ours is less than 20% of our gross income. Two months’ salary gets us covered for a year.
Risk attitude (or personal preference): remember, everyone get unlucky some day in life. That’s why we’re paying for health and car insurance. I am very conservative, thus, may want to insure for situations of very small probability, say three or four unfortunate incidents happening at the same time; you may be more optimistic and want to just insure up to two. However, you really do not want to have no or poor preparations for them as they do happen.

Last, I think having an EF is one necessary step for anyone to get started on investment and retirement savings. I will share my experience later.

What investments to hold in your IRA?

What investments to hold in your IRA?

I wrote a post to recommend Roth IRA earlier. Another article The Best Investments for Your IRA let me recall a class I took.

I took a PhD level tax class cross-listed in the finance department two years ago. I’ve forgotten most things learned in the class, since it’s pretty theoretical. However, sometimes the professor discussed some very practical questions at the request of the students. Think finance or economics PhD students are all financially savvy? Some students didn’t know what IRA was and asked this question to the professor.

There is no absolute answer. The common wisdom is to hold bonds and CDs in tax sheltered account since dividends and interests are usually not deferrable and taxed as ordinary income’s higher marginal rate. On the other hand, a buy-and-hold strategy for stock investments could defer the capital gain from price appreciation almost forever, which is much more tax efficient (same effect as a 401K type of tax deferment without employer matching). As a famous example, Warren Buffet argues that dividend is much worse to a shareholder than stock price appreciation, thus Berkshire Hathaway does not distribute any dividends despite being one the most profitable companies in the world.

However, some people argue that stocks should be kept in tax sheltered account because the expected annualized return for stocks is much higher than savings and bonds over the long term (>20 years). Given same contributions, stocks grow much faster. Therefore, this strategy gives more assets the tax benefit. This strategy makes even better sense for Roth IRA, since its future earning is tax-free, not tax deferred.

Assuming you have a portfolio of $10,000 bonds and $10000 stocks, with a marginal tax bracket of 33% (including both Federal and state income tax). The long term annualized return of bonds and stocks are 6% and 9% respectively. Compare strategy 1 of holding bonds in Roth, and stocks in regular account, and strategy 2 the opposite, what’s the outcome in 30 years? To simplify, let’s assume a passive stock investment using a highly tax-efficient ETF on market index, with 0.5% taxed on capital gain and dividends annually. Capital gains and dividends are reinvested.

Strategy 1 = 10000*1.06^30+10000*((1.085^30-1)*0.67+1) = 57.4K+80.7K=138.1K
Strategy 2 = 10000*1.09^30+10000*1.04^30 = 132.6K+32.4K = 165.1K

So keeping stocks in Roth IRA will win (Strategy 2). There are a few caveats on this conclusion:
This conclusion relies upon the 3% difference in annualized return between stocks and bonds. If as some authors have argued in their books that the future difference between the rate of return of stocks and bonds are about the same at 6-7%, you should hold bonds in Roth, and use a buy-and-hold strategy to defer taxes on capital gains from stock price appreciations.
The stock investment strategy is also critical. If we assume that the difference in the rates of return of the two are not that large, however, if you really trade your stocks frequently, then it’s still advantageous to keep your stocks in Roth.
I also learned both in class and from my experience how tax policy exerted distortion in your trading decision. I had hold stocks just to get the long-term capital-gain tax rate even though the market condition for that stock had turned south. If you want pure undistorted trading decision for yourself, hold stocks in Roth. On the other hand, you lose the leverage on claiming loss on your trades as well.

I hold stocks in my Roth and have done some trading. I really love the tax-free capital gains. Roth IRA is really a very powerful tool for us to catch up.

I only discussed bonds versus stocks. People have used IRA holding to buy futures, options, land contracts etc., which enable them to have larger leverage and gain larger tax-free earnings. However, if you are old enough to believe no free lunch, you will probably want to think about the risk carefully before shooting for the “big gain”.

Any questions and comments?

Roth IRA, a must-have tax benefit for graduate students and young professionals!

One common enemy on wealth accumulation for busy young fellows is not to start now. A few years ago, I started to work on my financial plan. The first thing I realized was how much I had missed by not using Roth IRA.

IRA is the abbreviation for individual retirement account. There are two types of IRA, traditional IRA and Roth IRA, sharing the same annual quota ($4000 for 2006) set by the Congress. For a traditional IRA account, you take a tax deduction up front for the money you put into the account, the contributions and earnings are not taxed until its distribution after retirement, which is called tax deferment. For a Roth IRA account, you put in after-tax money as contributions, your contributions and earnings grow tax-free even when it is distributed after your retirement.

For young professionals and poor graduate students, Roth IRA is better for the following reasons:
1. You will be likely in a higher tax bracket at your retirement compared to your tax brackets now. Most graduate students on a stipend are in the tax bracket of 15%. Compared to a 25% plus tax bracket with a real salary, Roth IRA is a big saving. Also, if you are an optimist believing in brighter future and higher earnings down the road, or if you are a pessimist believing in increasing Federal tax rates, you should contribute to Roth IRA instead of traditional IRA. Of course, if you are extremely pessimistic and worried about the Congress removing the tax benefits of existing Roth IRA in the future, you probably should store up gold and avoid investing.

2. It is more flexible. You can have early withdraws any time up to the total contributions without penalty. Of course, you won’t be able to put them back in later. So it’s NOT recommended. However, it was really attractive to me when I started as I was considering graduation and buying a house after getting a job.

3. No mandatory age-based distribution schedule like other tax-deferred retirement accounts. This allows you to manage your income stream after retirement, and enable you to pass all the dough to your descendants even.

4. You contribute more with Roth. Because the quota is applied on your after-tax contributions, $4000 in a Roth IRA is really worth more than the pre-tax $4000 in a traditional IRA. Therefore, it’s very attractive to a late-starter who is trying to catch up with the retirement contributions.

Now let’s see how much you can accumulate with Roth IRA only. Assuming an annual contribution of $4,000.00 in 2006 and 2007, and $5000 afterwards (the limit will be increased to $5000 in 2008), you will see $1,049,385 in 2041 if the annualized rate of return is 9%. Assuming you start at the age of 30, more than 1 million dollars will be there for you at the age of 65 tax-free. After considering an annual inflation rate of 3%, it’s still worth $544,822 of current dollars. Half a million in today’s dollar is probably worth more than most people’s equity in their house after they have paid off a thirty-year mortgage. Find a soul-mate and do it together? That will be even sweeter!

So if you haven’t taken advantage of the Roth IRA, I highly recommend you to do it. The deadline for 2006 contributions is 04/16/2007. You’ve still got time!