Global Tax Forum: Foreign Roth IRA Investors Face Additional Complexities

The complexities of the Roth IRA have provided an unending stream of questions for the Tax Forum. And it doesn't get any easier when you throw citizenship issues into the mix.

So the Global Tax Forum is tackling two Roth issues this week, and we'll also help a reader pay back a loan to a nonresident alien.

Any other issues you'd like us to address? Send your questions to [e-mail]. Please remember to include your full name and resident country. Don't forget -- the Global Tax Forum appears every other Wednesday.

Resident Alien Wants a Roth

Is the Roth IRA also for a noncitizen, resident alien? I am considering setting up a Roth IRA with a broker. I am not sure what would happen with the IRA when I leave the U.S. after four years. How would I withdraw the money after age 60 (I am 40 now)? What if I would like to tap the money for college expenses of my children outside the U.S.?

-- Dave Popel

Dave,

I swiped this question off the Tax Forum message board because it's a good one and I want to share it.

Ask your tax questions on the TSC Tax Forum board

As a resident alien, you can open a Roth IRA as long as you have taxable U.S. compensation. The catch is that the IRA -- Roth or traditional -- must stay in the U.S.

Remember, your Roth contributions are after-tax, and as long as you keep the account open for five years and are 59 1/2 years old, you can pull out all the money -- contributions and earnings -- tax-free.

But it seems you won't be 59 1/2 when you leave the U.S. And if you withdraw all the money at that point, you'll be hit with taxes on the account's earnings and a 10% early withdrawal penalty.

So it might make sense just to leave the money in the U.S. You can still take advantage of the exception that allows you to withdraw money from your Roth for higher-education costs without paying the 10% penalty. Just keep in mind that as long as you're under 59 1/2, you'll be subject to tax on any earnings the account generated.

But check to be sure that the foreign university you have in mind qualifies for the Roth higher-education exception, says Dick O'Donnell, editor at the Research Institute of America, an information provider to tax professionals.

And note that these are just the U.S. rules. Your resident home country may impose a tax on your withdrawals as well. So be sure to read your country's tax treaty with the U.S. for the specifics.

Overseas Roth: Part II

In the last edition of Global Tax Forum, reader Hardeep Dhindsap, a U.S. citizen working overseas, asked how the foreign-earned-income exclusion affected his ability to establish a Roth IRA or roll an existing IRA into a Roth.

The answer, in brief: You can exclude up to $74,000 of your foreign-earned income from your 1999 tax return. But since you need earned income to qualify for the Roth, you would need to earn more than $74,000 to set one up.

But that was only part of Hardeep's question. He also wanted to know how the exclusion affects the rollover of his existing IRA into a Roth. So here's part two of the answer:

IRA rollover rules say you only can convert amounts from a traditional IRA to a Roth IRA if your adjusted gross income does not exceed $100,000 and your tax status isn't married-filing-separately.

But when calculating your adjusted gross income for rollover purposes, you do not deduct the $74,000 foreign-earned-income exclusion, says O'Donnell. This is the opposite of what you would do to determine your eligibility to set up or contribute to a Roth.

Makes perfect sense, right?

So if you had overseas wages of, say, $70,000, then $70,000 is the amount that would determine whether you qualify for a rollover. And in that case, you could roll away.

Check out this previous Tax Forum for more on the Roth IRA contribution guidelines.

An Attempt to Pay Off a Debt

I am proposing to transfer stocks to a friend's brokerage account as payment of a debt. Since he is a nonresident alien, he can then sell the stock and be whole since he won't be paying any tax. And I will have saved paying tax on the gains in the stock.

How would this be viewed by the Internal Revenue Service?

-- William Page

William,

Your plan almost works. Your nonresident alien friend can sell the stock to repay your debt without owing capital gains tax. But here's the problem -- you'll owe capital gains tax instead.

If you transfer property to repay a debt, it is not considered a gift in the eyes of Uncle Sam. So the good news is that by paying off your debt with stock shares, you won't have to worry about gift taxes.

The bad news is that this transfer is considered a "deemed sale" in tax land, notes Martin Nissenbaum, national director of personal income-tax planning at Ernst & Young. That means the transaction is treated as if you sold the stock and paid your debt back in cash. So you'll owe the tax on the difference between your purchase price (your basis), and the fair market value.

Let's assume you owe your friend $9,000, so you transfer shares with a fair market value of $9,000. But the basis in these shares is only $3,000. You'll owe capital gains tax on the $6,000 difference.

If your friend were a U.S. citizen, he would get a step up in basis. That means he would get the shares at their fair market value -- at the value of the loan. But because he's a nonresident alien, his basis isn't really an issue in this case.

If you just give the shares to your friend out of the kindness of your heart, he would receive the shares at your original basis. In that case, your strategy would work. As a nonresident alien, your friend would not pay tax on any capital gains generated from the sale of the stock. And as long as the fair market value of the shares is below $10,000, you would not have to worry about paying gift taxes.