So, you're an American living overseas, and you want to start or continue investing. How can you best do it?
I have lived overseas for several years, and I intend to stay for
more years. I met with a financial advisor before leaving the US,
but he had trouble wrapping his mind around my situation. In the
end, his advice was reasonable, but you may find this page even more
I have no formal training in finance, but I've researched and thought
the options. And unlike a financial advisor, I'm not trying to
a commission from you. This is a wise but simple summary of the
issues, with practical recommendations.
First, some assumptions:
1. Saving is a good thing to do. We must not worry about tomorrow, but we should plan prudently as the wise virgins did (Mt 25). I will assume that we agree about that. If I retire to the US, I'd rather not need to be on support.Outline (all on this same page):
2. You don't want to spend a lot of time and energy tracking investments. You have better things to do! Also, you don't want to orient your life around money. The more we think about our money, the more we tend to treasure it.
As someone working overseas, the worst thing you can do is a Traditional IRA. With that, you save money on taxes now (but we don't pay taxes now), and you instead pay taxes later.1. You set up a Roth IRA account with a brokerage or mutual fund company. The investment can be in any mutual funds, stocks or bonds.
2. You invest up to $4000 per year for you, and up to $4000 for your spouse, into the Roth IRA. (But see note below as number 7.)
3. Those contributions have no effect on your taxes now. In other words, that $4000 is after-tax income. So the Roth IRA doesn't save you anything on your taxes now. (But you probably don't pay any taxes now, if you work abroad.)
4. The interest on your account accumulates tax-free.
5. When you turn 59.5, you can start taking out money, and it will be tax-free income. So, you don't pay taxes now since you're overseas, and you won't pay taxes later!
6. If you want to -- and I don't recommend it -- you can withdraw the principal tax-free before you turn 59.5. In other words, if you invested $40,000 over ten years and earned $35,000 in interest, then you can withdraw up to $40,000 with no penalty or tax.
7. Note on that $4000 maximum contribution per year: Official IRS rules in Publication 590 are that "Your contribution limit is the lesser of $4000 and your taxable compensation." If you have less than $4000 (or $8000 married) of taxable compensation, then you cannot put your taxable compensation into your Roth IRA. That means earned income which is not excluded through the Foreign Earned Income Exclusion. So if you live overseas, you cannot put into your Roth IRA more than the "Income earned in the US on business" on Form 2555 (line 14d in 2006).
A "non-retirement" account is just normal investments with no special tax advantages. This is probably better for non-retirement savings. You can put in or take out money when you want. Any interest and capital gains are taxable. However, if all of your other income is foreign earned income, you still might not owe taxes. For example, I am married and have two kids. In 2006, my standard deduction was $10,300, and four exemptions gave me another $13,200. So I would have only needed to pay tax if US-earned income (during US visits) plus investment income was more than $23,500.
For saving for college, there is also an "Education Savings Account" (ESA), formerly known as the "Education IRA." A child can have contributions up to $2000 per year, and withdraw the money tax-free for education expenses. Of course, this is only relevant if you have a lot saved, and you're starting to pay tax on the investment income (or if you expect to return to the US within a few years). There are a number of other options for tax-free education savings, some of which vary from state to state. Vanguard has a helpful downloadable brochure on "College Investing."
Another issue is qualifying for financial aid at colleges and universities. Your retirement savings (in an IRA) is not included in financial aid calculations, but your other assets and income are included. You can calculate your EFC (Expected Family Contribution) to your child's education by downloading the "EFC Formula Guide" from www.ifap.ed.gov. Do these calculations a few years before your children start college, to see what you will need to pay -- and to figure out how to reduce it.
If you have self-employment income, you have an additional
good option for retirement savings: Roth Solo 401(k). That's more
complicated to setup than an IRA, but it's not too difficult through 401kbrokers.com or T Rowe Price. It's a good
option if you have self-employment income and you want to save more
than your Roth IRA maximum. In 2007, you can contribute up to
$15,500 to a Roth Solo 401(k), as long as it's less than your
self-employment income. That $15,500 limit is not affected by
Foreign Earned Income Exclusion (as far as I can tell), and your limit
isn't affected by also contributing to a Roth IRA. Like a Roth
IRA, a Roth Solo 401(k) doesn't affect your current taxes, and you can
withdraw the money tax-free in retirement. Unlike a Roth IRA, you
cannot withdraw the principal without penalty before age 59.5.
Summary: If you're investing for retirement, put everything into a
IRA. Education saving has a few different options. Saving
other purposes is probably best in normal non-retirement accounts.
There are three main alternatives for your investment vehicle: stocks, bonds, and mutual funds. Stocks are more volatile, but have the best long-range returns. Bonds are more stable, but have smaller returns. (Money markets also exist; they are easy to work with, but have lousy returns.) Mutual funds are a collection of stocks and/or bonds. They are the best option, since:
1. Mutual funds are more diversified. This reduces risk a lot. It's not diversified enough if all of your savings are in Enron stock, Worldcom stock, and Argentine government bonds.It can be a lot of work to choose a mutual fund, however. There are lots of companies out there, and each one of them has a lot of options. Your main options with any one mutual fund company:
2. Mutual funds are a lot less work. I don't want to spend time tracking stocks. With mutual funds, I might get around to checking their performance every few months.
1. Stocks vs. bonds. Long-term, you're better off with stocks. But if you get stressed by unpredictable returns, or your investment horizon is short-term, you'll want more bonds. Some mutual funds are "blended," with both stocks and bonds included.Different funds have different sales fees or loads. That's a sales commission when you first buy the mutual fund, or if you sell it within a few years.
2. Large-cap vs. mid-cap vs. small-cap vs. international. Does the mutual fund focus on large, medium, or small companies? Small companies are the least predictable, but often have better long-term returns. Most mutual funds hold only US stocks and bonds, but some are international.
3. Growth vs. value. "Growth" companies are those expected to grow at a rate faster than the rest of the economy. "Value" companies are expected to grow more slowly, so their stocks are cheaper. Long-range, both have pretty similar returns.
4. Managed vs. index. This is very important, but a relatively new concept. "Managed" funds have professional managers who try to pick the best stocks. "Index" funds just try to mimic an index, by investing in the companies which make up the index. At this point, the largest mutual fund in the US is the Vanguard 500 Fund, which simply mimics the S&P 500 index. The surprising thing is that most index funds outperform the actively managed funds!
Another important (but often overlooked) issue is the cost
the fund. Many funds have various management fees which take
1.0% to 2.5% of your annual balance. Index funds are usually much
"cheaper," since the management is a lot easier.
I would strongly recommend Vanguard (www.vanguard.com). No, I'm not getting a commission from them. Vanguard is not the only good mutual fund company out there, but here are some great things about them:
1. Their website has excellent educational information on investing, via Adobe Acrobat files you can download. For example, read "Mutual Fund Basics" or "Fund Essentials."I started my retirement savings with another mutual fund company, and I bought funds through a financial advisor. The funds had costs around 1.6%, plus sales commissions of up to 5%. After someone recommended Vanguard to me, I switched over to better-performing funds which cost around 0.3% and have no sales commissions. And I don't need to contact my financial advisor every time I want to change something.
2. You buy Vanguard funds directly from Vanguard. So there's no middle-man getting a commission.
3. Their website contains all of the info you need. You can sit there on the Internet in Hagaristan and get all the info you need on different funds (look at "Facts on Vanguard Funds"), then print the forms and mail them. Once you've invested, you can get all information about your account via the Internet. You can also sell some of your investments and have the money sent directly to your US bank account.
4. Their costs are much lower than most other companies.
5. They offer lots of funds, including a lot of index funds.
When my wife and I switched over to Vanguard, we put everything we could into our two Roth IRAs, and the rest into a normal joint account. Overall, we divided our money over the following four funds:
40% in 500 Fund (following the S&P 500 Index of large-cap and mid-cap companies)The website Armchair Millionaire has a simple but wise model portfolio:
30% in Extended Market Fund (following an index of small-cap companies)
20% in Explorer Fund (actively managed, small companies, growth)
10% in Total International Index (following an international index)
This is set up for retirement, but you could also use it for other savings goals. There are lots of other resources on the Internet.
The best way to save is to have an automatic withdrawal from your checking account every month. That's easy to setup with Vanguard. (You first need to create a new account. With most Vanguard mutual funds, the minimum to start a Roth IRA or non-retirement account is $3000. So you may need to save up for several months before opening the account.)
Both you and your spouse should have Roth IRA accounts. But if you're like me, you can't afford to put the maximum of $4000 each into your Roth IRAs, which would be $667/month. If you already have some savings or inheritance not in Roth IRAs, you can gradually transfer that into your Roth IRAs.
Suppose, for example, that you have $15,000 in savings which you
to use toward retirement. You can only afford to put $100/month
each of your Roth IRAs. That adds up to $1200 per year. So
you could also do an annual transfer of $2800 from normal savings into
each of your Roth IRAs. This will gradually move all of your
savings into Roth IRAs.
Well, I hope that's helpful!
-- Peter Noonan