Increasingly unloved abroad, kicked out of foreign banks and shut out from financial products at home, hounded by FATCA, the TD-90.22.1 "FBAR," and Patriot Act and Anti-Money Laundering legislation, there seems to be no end to the challenges of managing finances abroad for American expats.
One of the biggest challenges faced by Americans overseas is funding retirement without access to the type of tax-advantaged savings vehicles available to their compatriots back home.
Long-term expats living and working abroad often lack access to 401ks and other corporate retirement savings plans. Pension schemes provided by non-US employers are either non-existent or not recognized by the IRS for tax-advantage treatment.
Funding IRAs can be problematic as well. Many American expats have no unexcluded earnings above the foreign earned income exclusion and therefore cannot make contributions to IRAs or Roths. Others earn above the income limits to contribute to a Roth IRA. And, while there are no limits on deductible contributions to Traditional IRAs if not contributing to a recognized company plan, the foreign country of residence does not recognize the deduction resulting in double taxation. The foreign country of residence taxes the contributions even though the US does not, and the US taxes the funds at distribution.
In any case, the contribution limits to both Traditional IRAs and Roths are well below the amounts that can be contributed to a typical US corporate retirement plan.
Considering these hurdles at first glance a variable annuity might seem to make perfect sense for the expat American.
Variable Annuity: Tax-Deferral and No Contribution Limits
A variable annuity is essentially an investment vehicle inside an insurance wrapper with a death benefit attached. Inside the insurance wrapper you can usually choose from a range of investment products called sub-accounts, which are like mutual funds.
Assuming the insurance wrapper meets US tax code specifications, investment earnings inside the wrapper are not taxed until distribution. And, there are no contribution limits as with 401ks, IRAs and other corporate retirement plans since you are making contributions with after-tax money.
Distributions can be taken without penalty after age 59 ½. Early withdrawals are subject to a 10% penalty on top of any tax owed.
Given the dearth of other tax-advantaged savings vehicles available, a US tax-qualified variable annuity seems like a no-brainer for the expat American.
What is the real value of the tax-deferral?
Variable annuities are sold, typically by advisors earning huge commissions, on their tax-deferral benefits. Since we all know that deferring taxes is a good thing, the analysis typically stops there.
But, how much is that tax deferral really worth?
Let's say you have $1,000 that you invest over a 10-year period earning 6% per year and investment earnings are taxed at your marginal rate of 33%.
If you invest for 10 years at 6%, your $1,000 grows to $1,790.80 before tax. After-tax, the value is $1,529.90.
If you invest for 10 years at 6%, but pay tax each year on the earnings at 33%, your $1,000 grows to $1,483.1. This is the after-tax value, since you've paid the taxes along the way.
The difference between $1,529.90 and $1,483.10, or $46.80, is the value of the tax deferral. For every $1,000, you earn an additional $46.80 after 10 years by deferring taxes rather than paying taxes every year.
- The longer the investment period, the greater the value of tax-deferral.
- The higher the tax rate, the greater the value of tax-deferral.
How Fees Change the Analysis
Since annuities aren't free (and neither is a portfolio of mutual funds/ETFs), we need to consider the costs as well.
Going back to the previous example, if we invest $1,000 in a variable annuity with fees of 2%, after 10 years it will be worth $1,480.20 before tax. After-tax it is worth $1,321.80.
If instead we invest $1,000 in a portfolio of ETFs with fees of 0.5% where the earnings are taxed each year at 33%, it will be worth $1,436.00. This is the after-tax value since the earnings were taxed each year along the way.
The taxable portfolio is worth nearly 9% more than the tax-deferred annuity. Why? The fees more than overwhelm the value of tax deferral. In fact, it only takes a fee differential of about 0.4% in this example to wipe out the tax-deferral benefit. This means that if the total fees on the annuity are only 0.9%, the benefit of tax deferral is more than offset by the additional fees. Typically, total annuity fees run well above 2%.
We've chosen an example that deliberately favors the annuity. It is unlikely that the earnings on the typical expat portfolio are taxed at 33% each year. A portfolio will be a mix of fixed income and equity. Fixed income distributions are taxed at the investor's marginal rate annually, but there is the option to hold tax-exempt bonds - often a good choice for expats in high tax brackets.
With equity, much of the return is deferred as capital gains so it avoids tax as long as deferred - just like the annuity. When the gains are recognized, they are taxed at capital gains rates (currently 15%) not marginal tax rates. Additionally, the portion of the earnings that are distributed are dividends, are also currently taxed at 15%.
Other Considerations with Variable Annuities
- No Tax Deduction: Unlike 401ks, IRAs and other types of retirement plans, contributions are not deductible. Taxes on earnings are deferred until distribution, and then taxed as ordinary income.
- Fees: Variable annuities are notorious for the fees they charge. Fees are charged for mortality fees (the cost of providing the death benefit)and other expense charges, administrative fees, sub-account management fees and fees for any additional riders. Total charges on the average variable annuity run from about 2% per year on the low side to 4%-5% on the high side.
- Surrender Fees: Annuities are often subject to surrender fees that range from 3% to 7% and can lock your funds up from 3-7 years. These fees are imposed to ensure the insurance company recoups the commission it paid to the "advisor" that sold the annuity. Trying to withdrawal your money during the surrender period will trigger the surrender fees in addition to any taxes and early withdrawal penalties due.
- Early Withdrawal Penalty: If you withdrawal funds prior to age 59 ½ you will be subject to an early withdrawal penalty of 10% in addition to any taxes owed.
- Taxes: Taxes on earnings are deferred until distribution, but instead of being taxed at long-term capital gains rates (currently 15%), they are taxed at your marginal income tax rate. This tax difference can easily overwhelm any benefit from tax-deferral even before considering fees and other potential drawbacks.
- Distributions: All distributions are deemed to be distributions of earnings first. Once all earnings have been distributed and taxed, future distributions are considered a return of principle not subject to tax. This treatment largely negates the tax deferral benefit once distributions start.
- No Stepped Up Basis at Death: Unlike stocks, mutual funds, and ETFs, there is no stepped basis at death. This means your heirs will be on the hook for taxes on any embedded gains in the annuity. With mutual funds and ETFs, the original cost basis is "stepped up" to the market value at death. Heirs are therefore not liable for taxes on earnings prior to inheritance.
- Foreign (Nonqualified) annuities: Americans overseas are often approached by financial salesmen selling annuities and other insurance linked investment products from foreign insurance companies. Often these insurance products do not meet IRS specifications and as such do not qualify for tax-deferral treatment. Additionally, the sub-accounts (or mutual funds) would then be treated as PFICs, subject to a special punitive tax regime. Unwittingly investing in these products could expose you to substantial penalties and interest charges in addition to the tax owed. Before investing in any offshore annuity or investment scheme, check with your tax or financial advisor.
Variable Annuities - Not as Attractive as They Seem
On first inspection, a variable annuity appears to be an ideal solution to the lack of tax-advantaged retirement vehicles available to expat Americans. A deeper analysis, however, tells a different story.
While variable annuities can be useful for some specific situations, they are probably not the best option for accumulating retirement savings for overseas Americans. Fees and other drawbacks more than overwhelm the benefits of tax deferral.
Constructed properly, a taxable portfolio can achieve much of the tax-deferral benefits of the annuity without the excessive fees and other drawbacks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Copyright © 2012 Creveling & Creveling Private Wealth Advisory, All rights reserved. The articles and writings are not recommendations or solicitations, and guest articles express the opinion of the author; which may or may not reflect the views of Creveling and Creveling.