It was 25 degrees Fahrenheit when I took my kids to the bus stop this morning. That’s freezing! Even though there were kids there in shorts and without jackets, for someone from Southern California like me, that’s a bit too much for my body to handle. My nose has already started running from subjecting myself to such unbearable temperatures. 

Runny noses are one of those annoying yet inevitable parts of life. Kind of like taxes. One of those things you know you’ll never be truly free of, yet you do everything in your power to limit. Because I believe in staying within my area of expertise, today we are going to talk about limiting taxes, though, not limiting runny noses. 

Today’s tip is for missionaries, or pretty much any American living abroad. This is it: utilize the foreign earned income exclusion to do tax-free Roth conversions in order to limit your tax liability in retirement. If none of that made sense to you but you live abroad and like the idea of saving on taxes, keep reading.

What Is The Foreign Earned Income Exclusion?

The United States of America is one of the only countries in the world that taxes its citizens no matter where in the globe they are located. The only other one is Eritrea. Most other countries tax people based on residency, not citizenship. 

What that means, though, is that if you’re an American living in Spain, you will be taxed by the Spanish government because you live there and the American government because of your citizenship. That doesn’t seem quite right, does it?

In order to help alleviate this unfair double taxation, the IRS has given us the Foreign Earned Income Exclusion (FEIE). The FEIE allows qualifying Americans to exclude some of their foreign earned income from US taxation. The limit adjusts every year for inflation and is $105,900 for 2019. To claim this exclusion you have to file Form 2555 and you can learn more about it here.

What Is A Roth Conversion?

The other key component of today’s tax-saving equation is a Roth conversion. Before explaining what that is, we need to do a quick review of retirement accounts.

The two types of retirement accounts available to Americans that aren’t employer-dependent are traditional IRAs and Roth IRAs. The difference between the two is taxation. With a traditional account, you put money in before paying taxes. Then you pay taxes on it when you take it out. With a Roth, you put money in after paying taxes and don’t owe anything when you take it out.

If you have money in a traditional IRA, you are allowed to move it to a Roth. This is called a Roth conversion. Because traditional IRA funds haven’t been taxed yet, when you move them to a Roth IRA they are included in your income so that you can pay income taxes on them. Once you’ve paid the taxes to get the money into a Roth account, everything you withdraw in retirement will be tax-free.

How Does It Work Together To Save Missionaries On Taxes?

So, how can you combine the Foreign Earned Income Exclusion and a Roth conversion to save money on taxes?

Let’s say you’re that missionary in Spain and you have $40,000 in a traditional IRA. For 2019, you will have $55,000 of earned income. Your income is well below the allowed FEIE of $105,900, so it will all be excluded from taxation.

Now, you’ve erased your tax bill but you still have the standard deduction available to you. In 2019, it is $12,200 for a single filer and $24,400 for a married couple. You can maximize the standard deduction available to you by converting that amount from your traditional IRA to a Roth tax-free.  

So, our Spanish missionary has their entire earned income excluded with the FEIE. Then, they list $24,400 as income from the Roth conversion and the standard deduction cancels it out for a total tax bill of $0. It would only take our Spanish missionary about 2 years to convert all of his retirement funds from taxable to tax-free. 

If our Spanish missionary is in a 12% federal income tax bracket when he retires, he will have saved $4,800 in tax dollars by taking advantage of the Foreign Earned Income Exclusion and standard deduction while living overseas. Pretty cool trick, huh?

Here are the steps again:

1. Live overseas.
2. Earn less than the Foreign Earned Income Exclusion limit.
3. Convert your standard deduction amount of traditional IRA funds to a Roth account.
4. Repeat each year until all of your IRA money is in a Roth instead of a traditional account.
5. Enjoy tax-free withdrawals in retirement.