The meaning of "nondeductible" IRA contributions?

[ryanf1475]

Hello all, please forgive my dunce-hood, but like the Lord of Idiots that I am, last year I was making traditional IRA salary deferments while qualifying for the Foreign Earned Income Exclusion. This is stupid of course because I could have excluded that income anyway. So, my question is: because I will still qualify for the FEIE this year, I assume it's not a bad time to convert some of that IRA to Roth IRA, as my taxable income will be very low this year. However, if I do that (with Form 8606) for this year, can I classify those traditional IRA salary deferments as "nondeductible" since I could have excluded them had they been regular income? And therefore, not be taxed on the conversion? Would the IRS buy this logic? Thanks for any guidance!!

 

[Taxing Matters]

Hello all, please forgive my dunce-hood, but like the Lord of Idiots that I am, last year I was making traditional IRA salary deferments while qualifying for the Foreign Earned Income Exclusion. This is stupid of course because I could have excluded that income anyway. So, my question is: because I will still qualify for the FEIE this year, I assume it's not a bad time to convert some of that IRA to Roth IRA, as my taxable income will be very low this year. However, if I do that (with Form 8606) for this year, can I classify those traditional IRA salary deferments as "nondeductible" since I could have excluded them had they been regular income? And therefore, not be taxed on the conversion? Would the IRS buy this logic? Thanks for any guidance!!

The fact that the income you used to invest in the traditional IRA would not have been taxed had you just taken the cash because of the foreign earned income exclusion is very different from whether the IRA contribution would be eligible for the IRA deduction. As a result, you cannot characterize them as nondeductible because the income used to contribute to them would not have been taxed. Unfortunately, you cannot fix this mistake after the fact.

 

[davew9128]

Are we to assume your salary exceeded the FEIE? Otherwise I don't see how you could have contributed to an IRA in the first place.

 

[ryanf1475]

Are we to assume your salary exceeded the FEIE? Otherwise I don't see how you could have contributed to an IRA in the first place.

Well no, it did not exceed the FEIE, but I am not sure that I "contributed" to an IRA -- these were actually just pre-tax salary deferrals into a 457, so it's not actually an IRA, I believe. I believe these deferrals are allowed regardless of what my taxable income is...

 

[Taxing Matters]

Well no, it did not exceed the FEIE, but I am not sure that I "contributed" to an IRA -- these were actually just pre-tax salary deferrals into a 457, so it's not actually an IRA, I believe. I believe these deferrals are allowed regardless of what my taxable income is...

IRC 457(b) plans are indeed distinctly different from IRAs. They are deferred payment plans for state/local governments and for certain charitable organizations. So the rules differ a bit between the two. But they share the general rule that contributions are limited to amounts included in income. Section 457(b) plans contributions are limited to what IRC § 457(b)(2)(B) calls "includible compensation". That term is defined in § 457(e)(5) as having the same "meaning given to the term 'participant's compensation' by section 415(c)(3)." The regulations under § 415(c) explain that compensation means:

(1) The employee's wages, salaries, fees for professional services, and other amounts received (without regard to whether or not an amount is paid in cash) for personal services actually rendered in the course of employment with the employer maintaining the plan, to the extent that the amounts are includible in gross income (or to the extent amounts would have been received and includible in gross income but for an election under section 125(a), 132(f)(4), 402(e)(3), 402(h)(1)(B), 402(k), or 457(b)). These amounts include, but are not limited to, commissions paid to salespersons, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses, fringe benefits, and reimbursements or other expense allowances under a nonaccountable plan as described in § 1.62–2(c).​

​

26 C.F.R. § 1.415(c)-2(b)(1)(bolding added). As you can see from the bolded portion, like IRAs, you can only contribute to a 457(b) plan compensation that is includible in gross income, other than the few exceptions listed. The election for the foreign earned income exclusion under IRC § 911 is not one of those listed. And the foreign earned income exclusion is an exclusion from gross income, thus compensation excluded under § 911 cannot be used for the contributions to a § 457(b) plan. So if you had no compensation that was included in gross income you were not eligible to contribute to the 457(b) plan (or to a traditional IRA, either).

 

[davew9128]

I would also then question who the employer was that allowed the contributions, because:

a) Most US companies use foreign affiliates to employ people outside the US
b) Foreign companies do not establish US based retirement plans
c) Foreign companies establishing foreign retirement plans are almost never recognized as such for US tax purposes, meaning its not considered a qualified retirement plan.

 

[LdiJ]

I would also then question who the employer was that allowed the contributions, because:

a) Most US companies use foreign affiliates to employ people outside the US
b) Foreign companies do not establish US based retirement plans
c) Foreign companies establishing foreign retirement plans are almost never recognized as such for US tax purposes, meaning its not considered a qualified retirement plan.

Dave, I have had lots of clients over the years, including recently, who are paid by a US based company while they are working overseas. A big tech company is one of them.

 

[davew9128]

Dave, I have had lots of clients over the years, including recently, who are paid by a US based company while they are working overseas. A big tech company is one of them.

A US company or a foreign affiliate?? No business in their right mind operates cross border without layers of corporate separation. Too much exposure from conflicting laws.

 

[LdiJ]

A US company or a foreign affiliate?? No business in their right mind operates cross border without layers of corporate separation. Too much exposure from conflicting laws.

I hesitate to specify a company but again, it was a US tech company, and the US company directly paid the employee. He got a regular W2. He was an employed international sales and service rep who was based in Asia.

I have had a lot of other clients in similar situations. Paid by US companies who placed them abroad and they got regular W2s. Now, I will admit that none of them were intended to be permanent placements, most of their assignments lasted only a few years, but they got regular W2s. Not a single foreign affiliate involved in the ones I am talking about.

One of the other members of our firm has a client who works for a large company who has been based in half a dozen countries over the last 10 years, and all of that time paid directly by the US company, with a regular W2.

It is what it is. I understand the logic of your feeling that it does not make sense exposure wise, but again, it is what it is.

 

[ryanf1475]

Thanks for all the info. Should be fun amending this one. In any case, my employer is a US public university who sent me overseas to teach at a partner school.

 

[Taxing Matters]

A US company or a foreign affiliate?? No business in their right mind operates cross border without layers of corporate separation. Too much exposure from conflicting laws.

Some companies, including some U.S. corporations, do operate in some countries in branch form. There are a variety of reasons for that. Less do it today with the ability to check the box to make a foreign affiliate disregarded, but it does still occur. It's not as crazy as you may think. It really depends on the country and the nature of the business being conducted.

 

[ryanf1475]

Ah, it looks like there are a number of options to "self-correct" this error, as described here:

https://www.irs.gov/retirement-plans/correcting-plan-errors
Does anyone have experience with any of these options, or advice about what would be easiest?

Thanks!

 

[LdiJ]

Ah, it looks like there are a number of options to "self-correct" this error, as described here:

https://www.irs.gov/retirement-plans/correcting-plan-errors
Does anyone have experience with any of these options, or advice about what would be easiest?

Thanks!

I believe that information is for the employers to correct errors rather than the employee. You really need to discuss the problem with the HR person who handles your plan's administration.

 

[ryanf1475]

I am thinking it might be easiest to simply amend my taxes to include as taxable income the exact amount that I contributed to the 457. (in other words, decrease the FEIE by that amount). That way, I don't have to withdraw anything from the 457. Does this sound reasonable?

 

[davew9128]

I am thinking it might be easiest to simply amend my taxes to include as taxable income the exact amount that I contributed to the 457. (in other words, decrease the FEIE by that amount). That way, I don't have to withdraw anything from the 457. Does this sound reasonable?

Would seem to me that if it was a US employer that your 457 contributions are deducted from box 1 of your W-2.