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!

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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?

Tax returns with incomes from two states, file jointly or separately?

NOTE: Enter a lottery before Noon Sunday (03/25) PT, for a free download of TaxCut Premium (Federal + State + efile) , retail value of $64.99. at my other web site: http://www.latestartersblog.com!

I finished our tax return last weekend, which was much more time-consuming than I had expected. For 2006, Jacqui and I need to file income taxes with two states because both us graduated and moved. Jacqui had income from her job in the current state, while my full year income was from the previous state.

Starting from Federal tax return, we needed 1040 because we had over $1,500.00 in interest and capital gains respectively, and a tax treaty benefit to claim. I used TaxCut to extract our financial transactions and categorized spending from our Microsoft Money account. It filled in 1040, lacking the tax treaty benefit; automatically produced Schedule B, D and schedule D-1 with short term capital gain and long term CG separated, which was very slick. I downloaded 1040 etc. and fill in the forms electronically in Acrobat Reader to claim a treaty benefit which TaxCut does not include. So the 1040 in TaxCut was not usable directly, but the Schedule B and D were. I knew what change I need to make on 1040, thus, I was able to reference the TaxCut 1040 often to make sure I wasn’t missing any deductions. We did not have a mortgage to pay, therefore Schedule A was empty.

Getting into State tax returns, I was first surprised to see the states claim tax on both in-state income and out-of-state income for state residents; and in-state income for non-residents. To be concrete, the first state is a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin) which claims all my income derived in the state and half of Jacqui’s income as taxable as long as we were the residents of that state. The 2nd state is better in the sense that it will claim Jacqui’s 100% income as taxable while my income as taxable only if I am a resident of the state.

Generally speaking, married filing jointly shows less Federal tax compared to filing separately. On the other hand, filing separately would allow us to claim resident status in two states separately, which minimizes our state taxes. However, you cannot mix and match. You need to have the same state filing status as the Federal filing status. Filing separately disqualifies us as a couple from Roth IRA contributions (AGI > 10000), which we already made in early 2006. We could withdraw our IRA contributions and pay taxes on capital gains before this April 16th; however that will be quite a hassle. For the reasons I stated before, I do not want to lose this tax benefit.

As the state income taxes do not amount that much compared to federal taxes, my strategy is to file tax return jointly, but try to minimize state taxes. The solution is to establish the domicile for both of us (permanent legal address) in the new state with lower income tax rates as soon as possible (since Jacqui moved there), so that Jacqui’s job income (higher than my PhD student stipend) will be taxed only in the new state. Of course, as I moved to the current state, my income in the 2nd half of the year become taxable in the current state as well. However, I found a schedule to claim a tax credit for the tax rate paid and the previous state. Most states have similar schedules for you to claim credits on taxes paid to other state governments, however, usually the lower-rate states give credits only up to an allowance computed using lower-rates. So you could avoid being double-taxed, but will still be taxed at higher rate if unlucky.

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!