Tax strategies for Americans in Bermuda

In this world nothing can be said to be certain, except death and taxes. 

– Benjamin Franklin

Even under the most conventional of circumstances, American taxpayers struggle to fully understand the myriad of tax advantaged retirement investment options they have.  

A 401(k) is an employer pension plan that offers one of the many possible investment choices from which American taxpayers living abroad might benefit.  

This type of plan has different tax implications, contribution limits and other features. Being an American expat, however, further complicates matters by injecting additional tax complexities into the equation.  

The good news is that Americans living abroad generally have the same opportunities as do Americans at home to accrue tax benefits from a tax-advantaged retirement account such as a 401(k) plan.  

In fact, under certain circumstances and with proper planning, expats may gain more than most from the proper employment of these types of accounts.

To aid American expats living in Bermuda sort out the financial complexities of planning for their retirement, addressed below are a few key topics in retirement planning to consider.

If you have an inadequate level of retirement savings, now is the time to begin closing the gap between what you have and what you will need.  Ideally, utilize a tax advantaged savings vehicle, such as a qualified retirement plan or a 401(k), which would provide a combination of immediate tax benefits and tax benefits for decades to come.  401(k) is an employer sponsored retirement account with generous employee contribution limits. 

Generally, you can contribute up to $17,500 (same as 2013) per year if you are less than 50 years old or up to $23,000 (same as 2013) if you are 50 years old or older. Additionally, many employers match contributions and provide discretionary profit sharing contributions.

There are several benefits to participating in a 401(k) plan. The key advantage is the tax-deferral of earned income.  

With this type of qualified plan, you set aside part of your gross pay, which results in lower taxable income.  

This translates into postponement of federal and state income taxes on the contributed amount and that saves you taxes today.  

As a participant in a 401(k) plan, you can also save taxes on the earnings as they are deferred until money is withdrawn from the plan.  

Lastly, when you retire, your income often drops, putting you into a lower tax bracket than you had as an employee.  

Therefore, money withdrawn from a tax-deferred 401(k) plan during the retirement years gets taxed at a rate lower than what you would have paid while still employed.

Another feature a 401(k) plan could offer is the Roth option.  This option allows you to make after-tax contributions.  Unlike a traditional 401(k), employee contributions to a Roth 401(k) have no effect on your taxable income when they are deducted from your paycheque.  This means you are effectively paying taxes as you contribute, so you won’t have to pay taxes on your contributions when you withdraw. Earnings on the Roth employee contributions will grow tax-free as long as you keep the account until you’re 59 1/2 and you’ve had it open for at least five years.  

Savers who believe their income during retirement will be low usually opt for the traditional 401(k).  Those who predict they will have higher income at retirement prefer the Roth 401(k).

A special consideration for American expats: if you fall below the Foreign Earned Income Exclusion of $97,600 for 2013, you aren’t paying any federal income tax. Therefore, you might benefit more from the Roth option. This option is also appropriate if you are wealthy and your estate will exceed the estate tax exemption.

Ultimately, just like in your investment portfolio, diversification is paramount when it comes to tax-deferred contributions.  Therefore, contributing to a traditional 401(k) is beneficial if your tax rate goes down (you pay taxes later), while contributing to a Roth 401(k) is beneficial if your tax rate goes up (you pay taxes now).  So, contributing to both helps smooth out the benefits no matter which way your tax rate goes.  

There is so much uncertainty about what future tax law will be and each individual’s relevant circumstances will vary considerably. Thus, it is difficult to give a comprehensive guidance in this matter. As always, it is best to consult with your tax consultant before making a final decision.

Veneta Alexieva is a financial consultant at AFL Investments.