401(K) and IRA – should expats invest in retirement plans?

Many overseas Indians and expats settled in the United States of America face a common dilemma – should they invest in a 401(K) plan or an IRA (Individual Retirement Account).

The confusion is more prominent among non-US citizens or those without permanent residence status in the US.

Many Indians working in the US have plans to return to India and would like to withdraw their contributions from their retirement plans.

Here’s the dilemma – if a non-US citizen contributes to a 401(k) plan at work, he makes tax savings on that amount. He also benefits from tax-deferred growth and employer match. However, if he chooses to withdraw his contribution early, he may be subject to taxes and a 10% penalty.

Is it then worth contributing to a 401(K) and a traditional IRA or Roth IRA for Indians?

While the concerns are valid, it should not hold you back from considering saving for your future retirement.

If you are a permanent resident (green card holder) when you leave America, it is easy to address the question of Federal taxes. You can use a phased withdrawal approach to minimize taxes. The idea is to withdraw only enough money each year to reduce the impact of taxes upon withdrawal. You can also reduce the 10% penalty for early withdrawal by rolling over the 401(k) to an IRA and then converting to a Roth IRA, subject to the restrictions for IRA rollover and Roth conversions. Speak to your tax consultant.

In fact, the problem is not so much about taxes in the US. You need to consider the taxes you will be required to pay in India, if you decide to take your savings back with you to India.

Indian residents are taxed on  their  income earned anywhere in the world, and a payment from an IRA is income.

However, there’s a ray of hope. India provides a special “semi-resident” status for those who worked abroad and returned to India. When in this status, income from foreign sources, including from retirement plans, are not taxed. Unfortunately, this status lasts only for a few years, so any phased-withdrawal strategy will have only a limited benefit.

For most overseas Indians who have invested in 401(K) or IRAs, the best thing to do is not withdraw money from the 401(k) account, if this is allowed, or to roll over to an IRA and leave it there until they are 60 years old. IRA custodians like Vanguard and Fidelity allow non-citizens to keep their IRAs even if they are no longer living in the US.  You can easily keep track of these accounts via internet from anywhere.

However, for these options to work, you need to be a permanent resident.

If you are not a green-card holder, then you are a non-resident alien and attract a 30% federal tax on IRA distributions when you leave the country . Also, the IRA custodian is required to withhold this 30% when the distribution is made. This harsh penalty may severely limit any benefit gained through tax-deferred growth and employer match on the 401(k) contributions.

In short, if you are not a green-card holder, there’s little point in investing in 401(K). But that’s a short-term view with the assumption that you intend to return to India after a few years. The truth is, most NRIs end up staying back in the US, get green card and retire. By then, it is too late to plan for the retirement.  They miss the valuable 401(K) boat.

What’s the difference between a 401(k) and an IRA?

Most people don’t know the difference between a 401(k) and an Individual Retirement Account (IRA).  All they know about a 401(k) is you can start withdrawing after you are 59-1/2 years old without attracting a penalty.

Here’s the difference – 401(k) is a pension plan and is offered through your the employer,  and involves your contributions and often contributions from your employer, whereas an IRA is a private investment funded solely by your money.

Secure your retirement with 401(k) easily

The maximum amount an individual can save in a 401(k) is $16,500 a year, or $22,000 if you’re 50 or older. If you can save that much, you should. If not, then grab your employer match. Many employers suspended 401(k) matches during the great recession, but they are starting to reinstate them. Make sure you contribute at least enough to get the matching contribution.

Each year, you can contribute as much as 15 percent of your salary or $10,000, whichever is less.

An employer can make similar contributions. Some companies contribute 33.3 cents to 50 cents for every $1 the employee contributes. What’s more, this amount is tax-deferred.

What’s the difference between traditional IRAs and Roth

Traditional are the old IRAs and Roth are the new ones. Roth are a better investment, unless you need deductions.

Traditional IRA: Any person working or receiving alimony can contribute to an IRA. Your employer does not contribute to your IRA, like 401(K).

You can go to a renowned investment company like Vanguard, Fidelity for opening an account. The maximum contribution each year is $2,000 in most cases. This limit is lower for higher income earners. Contact IRS for details.

Under IRA as well as  401(k) plan, you can withdraw funds without penalty after the age of 59-1/2.

However, if you are serious about your future, invest in Roth IRA. The bad news is the Roth is not deductible. But the good news is, the lock-in period is only five years. You must keep your money for at least five years in a Roth. If you withdraw within the first five years, you have to pay a 10 percent penalty. The amount you contribute is not taxable.

If you withdraw after you turn 59-1/2,  your withdrawals will not be taxed. Neither your contributions nor the capital gains are taxed. And this is the biggest advantage of investing in a Roth.

Because the maximum annual contribution is $2,000, it is to your benefit to start early and invest in a Roth IRA.

Think long-term.

(About author: Sanjeeve Pai is an investment advisor for overseas Indians. Views expressed here are for guidance only. Please seek professional advice before making investment decisions.)