Investment can be a challenge for any expat. In particular, Americans living in Japan face obstacles that can make investing seem an impossible task. One such obstacle is the tax laws in Japan and America. Both the United States and Japan have strict international tax laws. Failing to adhere to tax laws has dire consequences. However, tax laws are only part of the investment dilemma expats face.
FBAR and FATCA Considerations
The Foreign Account Tax Compliance Act, known as FATCA, is a major complicating factor expats living in Japan face. FATCA requires the finances of Americans living abroad to be fully transparent.
As part of FATCA, foreign financial institutions (FFIs) typically must disclose the financial information of American clients worth more than $50,000. In addition to FATCA requirements imposed on the financial institutions, Americans must report on their FBAR (Report of Foreign Bank and Financial Accounts) any financial accounts once the total of all accounts exceeds $10,000 or the foreign currency equivalent.
Suppose an American expat holds Japanese stocks in an account with Nomura holdings, a popular Japanese brokerage. FATCA dictates these stock holdings must be disclosed. And FATCA isn’t an honor system; the US requires FFIs to send the financial information of American clients to the IRS.
The IRS taxes foreign investments as either ordinary income or as capital gains. Whether the investor pays ordinary income tax or capital gains tax is dependent on the assets they hold.
The IRS punishes those who fail to comply with FATCA of FBAR requirements. For instance, the fine for being even a day late filing your FBAR can be up to $10,000, and the most severe tax evasion can of course involve prison time. This extra filing requirements and strict potential penalties can make investing for Americans in Japan more stressful than it needs to be.
US Income Taxes
Taxes on International Income
Any Foreign Earned Income (FEI) is subject to taxation. FEI is income an American earns in any country or territory outside of the United States. Salaries, wages, bonuses, and commissions all constitute FEI.
FEI taxes create an issue of potential double taxation. This means Americans working abroad could be taxed twice on their income. For example, consider an expat who earns $80,000 (~¥9.3 million) in Japan. Furthermore, suppose they face an income tax rate of 20% in both Japan and the United States.
In this case, the expat could end up paying $32,000 in income taxes. A Japanese person with the same income would only pay $16,000. This double taxation could put American expats at a major financial disadvantage.
Luckily, American taxpayers can avoid some if not all double taxation by taking advantage of several important deductions and exclusions.
Foreign Earned Income Exclusion (FEIE)
The Foreign Earned Income Exclusion (FEIE) allows Americans to exclude the first $112,000 of FEI from their tax bill.
For example, suppose an American working in Japan earns the equivalent of $150,000. With the FEIE, Bill is only liable for taxes on $38,000 ($150,000 – $112,000) of foreign earned income.
Any income over the FEIE can be subject to double taxation; both Japan and the United States will take a piece as income tax. In the above example, both Japan and the United States would tax Bill’s $38,000.
Qualifying for the FEIE
To qualify for the FEIE, an expat needs to pass the bona fide residence test, or the physical presence test.
The bona fide residence test requires that Japan is an expat’s primary residence for the tax year. Short trips back to the United States won’t cause an expat to fail the bona fide residence test. However, they need to prove that Japan is their primary residence.
The physical presence test requires expats prove they lived in Japan for 330 days in the last 12 months. The physical presence test is not constrained by the calendar tax year. If the expat can prove they lived in Japan for the last 12 months, regardless of which months, they qualify. It may seem more strict that many anticipate (most just assume it would be only 180 days out of the current year), but the IRS allowing you stretch back into the previous calendar year gives plenty of flexibility. The IRS website explains this FEIE physical presence test calculation in full detail for those that are interested.
For example, if an expat can prove they lived in Japan from June 2020 through June 2021, they pass the physical presence test. The physical presence test does not require the expat to live abroad for the calendar year. For Americans living in Japan it should be no issue qualifying for the FEIE, and most base their investing strategy around the assumption of using the FEIE.
Foreign Tax Credit (FTC)
Although the United States taxes foreign earned income, the Foreign Tax Credit (FTC) can eliminate foreign income taxes. Unfortunately, failing to take advantage of the FTC leads to double taxation—paying income tax to Japan and the United States.
With the FTC, an American expat who earns income and pays income taxes in Japan can offset United States tax liability by the amount they paid to Japan. Americans can take advantage of the FTC through a tax credit, or a tax deduction. There are nuances regarding credits and deductions. Tax experts can help determine whether somebody should take a credit or a deduction.
Americans living in Japan can calculate the maximum FTC using the following equation:
Overall, the FTC requires more work and documentation in order to properly file when compared to just taking the FEIE. But, in some cases it can enable more investing options for Americans living in Japan. Also, while it may not completely eliminate double taxation, the FTC still saves expats thousands of dollars each year. However, the United States offers several other tax breaks that expats living in Japan should know about.
Foreign Housing Exclusion (FHE) and Foreign Housing Deduction (FHD)
Expats can also use the Foreign Housing Exclusion (FHE) and Foreign Housing Deduction (FHD) to reduce the tax burden associated with living abroad.
Expats can use the FHE to exclude employer paid housing expenses from taxable income. The FHD is similar; it allows expats to deduct housing expenses that they paid out of pocket. Expats need to pass the bona fide resident test or physical presence test to use the FHE or FHD.
Unfortunately, there are some nuances regarding what can be classified as a housing expense. The IRS limits the FHE and FHD to ordinary housing expenses such as rent and mortgage interest. Housing expenses other than rent and mortgage interest, like furniture, don’t qualify for the FHE or FHD.
Furthermore, anything expats purchases to increase home value is not a qualifying expense. For example, suppose an expat remodels the bathroom in their Japanese home. In this case, they cannot count the cost of the remodel towards the FHE or FHD.
Because of these nuances, expats can benefit from consulting a financial advisor before filing for the FHE or FHD.
Investment Options for American Expats Living in Japan
Despite the obstacles, investment in Japan as an expat is possible. However, it may require creative help from financial advisors. Nonetheless, successful investment as an expat is possible.
There are a variety of ways to invest as an expat. The most common investment methods American expats use are the following:
(1) Continue Investing in American Brokerage Accounts
A simple option is to continue using American brokerage accounts. There is nothing stopping expats from transferring money back home.
One drawback to this strategy however is that it does require making regular transfers back to the states. However, over the recent years improvement in banking capabilities have made this much easier. Low-cost services such as Wise (formerly “TransferWise”) can enable to make international bank transfers at near-zero cost and with virtually no F/X exchange fee. They can even allow automated transfers for certain small amounts.
One of the most popular benefits of using an American brokerage account is the simplification of your US tax filing obligations. At the end of each year, US-domiciled brokerages provide a full summary of all taxable details (interest, dividends, capital gains, etc.), making it very easy for you file your taxes. Brokerage accounts outside of the US will be formatted for their own country, and you will need to manually track all taxable events and determine your US tax liability from scratch.
In some cases, American financial institutions will close an expats account. There are several reasons why this will happen, but usually could be triggered by not maintaining a US residential address. Most Americans living in Japan or other countries abroad will simply use a parent or sibling’s home address for their bank or investment account, and this is generally acceptable with the financial institution.
(2) Giving Up Citizenship
Another option is to surrender American citizenship. Of course, there are benefits to having American citizenship. However, those who don’t plan a return to America can simplify their personal finances by renouncing citizenship.
As mentioned, FATCA makes it costly for Japanese financial institutions to work with Americans. Surrendering citizenship means American expats are no longer FATCA liable. Consequently, doing so will make it cheaper and easier for Japanese financial institutions to take them as clients.
However, there are exit taxes. Expats who have substantial assets in America could face harsh taxation for renouncing their citizenship and withdrawing assets. You are also virtually certain to face an adversarial audit from the IRS in the event of giving up your citizenship. This means you will need be certain your books are spotless going back up to 5 years.
Renouncing American citizenship is not for everyone. Expats should consult a trustworthy financial advisor familiar with the unique needs of Americans before they make permanent decisions.
(3) Putting Money in Partner’s Account
This is an option for expats with Japanese partners. It’s not uncommon for expats to store their wealth in the accounts of their Japanese partners. However, when somebody puts their assets under another person’s name, they are putting their financial future at risk. Also, if their partner ends up becoming a US resident or US taxpayer, this could turn the whole plan upside down.
If not married, their partner could run away with all their money. If married, a divorce could be a total mess if all the assets are under one partner’s name. Nonetheless, regularly gifting wealth to a partner, or accumulating wealth as a couple in the non-US citizen’s name is a commonly used approach to investing for Americans in Japan. This is a simple solution that should be fine for small amounts early in a relationship, but for longer-term planning and for larger sums of money it is much more sensible to put together a more reliable plan.
Tax-Advantaged Investment Accounts
Once American expats living in Japan understand the tax implications of living abroad, they need to figure out how they can maximize investment returns. The good news is Americans have access to tax advantaged investment accounts: Individual Retirement Accounts (IRAs), employer-sponsored 401Ks, and 403Bs for government employees. The bad news is, at the end of the day most Americans in Japan will not receive substantial benefits for investing in these accounts that are designed for non-expats.
Roth vs. Traditional
There are two types of IRAs, 401K, and 403Bs: Roth accounts and traditional accounts. Essentially, the choice between Roth and traditional accounts allows the investor to decide how they want to receive tax privileges.
First, consider Roth accounts. With Roth accounts, an investor pays taxes on income before they contribute it to their account. However, when an investor withdraws their money, they do not pay capital gains taxes.
Roth accounts are best suited for those who are typically younger and in lower tax brackets.
Now consider traditional accounts. Traditional accounts are the opposite of Roth accounts. The income an investor contributes to a traditional account is not subject to income taxes. However, the withdrawals are subject to capital gains taxes.
Traditional accounts are usually best suited for people who are more advanced in their careers and in a higher tax bracket.
Individual Retirement Accounts (IRAs)
IRAs are the most straightforward tax-privileged accounts. Anyone with a taxable income can open an IRA. Since IRAs are independent of employers, the international tax implications are not as complicated as those of the 401K.
In 2022, Americans under the age of 50 can contribute up to $6,000 annually to their IRAs; Americans over the age of 50 can contribute up to $7,000 annually. However, American expats living in Japan face certain limitations on IRA contributions.
The good news is that expats can still contribute to their American IRAs from abroad. The bad news is that the FEIE and FHE conflict with IRA contributions. To contribute to an American IRA from overseas, Americans need to have taxable income leftover after the FEIE and FHE.
The United States government limits the actual amount an expat can contribute to an IRA based on: (1) how much income they report and pay taxes on and (2) the standard IRA contribution limits mentioned previously.
Suppose an expat pays taxes on $10,000 worth of FEI. In this case, they can maximize their IRA contributions (either $6,000 or $7,000, depending on age).
On the other hand, suppose they only pay taxes on $5,000 of FEI. In this case they can only contribute up to $5,000 to their IRA.
401Ks are employer sponsored tax advantaged investment accounts. With 401Ks, the employer will set aside a portion of the employees’ compensation in an investment account. When the employee turns 59.5 years of age, they gain access to their 401K money.
Consider George, a Starbucks regional manager in Northern California. After years of hard work in America, George would like the chance to move abroad. Fortunately for George, Starbucks is an international firm, and there is an opening for a regional manager position in Tokyo.
If George moves to Japan, he plans to return to the US for retirement. Unfortunately, he’s worried about saving for retirement while living abroad. Specifically, he wonders if he can still maximize his 401K contributions while living in Japan.
While moving abroad is multi-faceted and complicated, rest assured, George can still contribute to his 401K. These 401K contributions from abroad follow the same FEIE and FHE rules that IRAs follow. The amount an American expat living in Japan can contribute to an IRA depends on how much FEIE they take, and how much of FHE they take.
Every individual is a case by case situation that will depend on your income levels and whether you use tax credits or the FEIE. However, unfortunately, the general rule of thumb is that for an American living in Japan, investing into an IRA or 401k is not a viable strategy.
Japanese Tax-Advantaged Investment Accounts: NISA and iDeCO
American expats who overcome FATCA and want to invest with Japanese accounts have options. NISA and iDeCo are two of Japan’s most common tax-privileged investment vehicles. These accounts are independent, like IRAs.
Nippon Individual Savings Accounts, or NISAs, are short-term tax-privileged investment accounts. Any resident of Japan 20 years of age and above can use NISA to decrease their investment taxes and supercharge their wealth for a 5-year period.
Investors can make NISA contributions after they have paid income tax. The tax benefits come upon withdrawal; investors don’t have to pay taxes on the capital gains that have accrued in their NISA. After the 5-year investment period, NISA holders must withdraw their holdings.
iDeCo offers investors long-term tax privileges, geared towards retirement savings. Those who invest with an iDeCo account are locked in for the long-run; they cannot withdraw their money without penalty until they are 60.
The significant benefit of iDeCo is that contributions are income tax deductible. Income tax deductibility is an iDeCo feature that resembles traditional IRAs, 401ks, and 403Bs. Essentially, investors can reduce income taxes with iDeCo. Not having to pay income tax allows investors to contribute more to their accounts than they could otherwise.
Most Common Investing Mistakes for Americans in Japan
Considering how complicated living abroad is, it’s not surprising that American expats make mistakes. These are a few common mistakes financial advisers see American expats making.
Not Investing at All
Perhaps the biggest, and one of the most common investment mistakes expats make is not investing at all. Many expats, facing the complexities of international rules and regulations, decide to surrender and hope for the best. However, doing so leads to pain and misery later in life.
Both the United States and Japan are known for having inadequate government pension programs. Those who want a fulfilling retirement need to save and invest during their working careers. Expats who are struggling to navigate international investment options should seek professional financial advice.
Not Exploring Japanese Investment Options
Some expats, primarily due to fear of the unknown, decide to only contribute to preexisting American investments. This approach, while better than not investing, has some drawbacks.
First, Japan offers a wide variety of great investment opportunities. Americans living in Japan could further diversify their portfolios by taking advantage of Japanese investment opportunities.
Also, international tax laws focus largely on limiting remittances. Imagine an American who has lived in Japan for several years. If they decide to retire in Japan, they may want to liquidate American assets and transfer their wealth to Japan. Unfortunately, exit taxes exist, and they can be harsh.
Thus, it may be beneficial for Americans living in Japan to hold both American and Japanese assets. Holding assets in both countries can reduce taxes and provide more flexibility.
Underestimating the Future Costs of Living
Time and time again, expats underestimate the costs of living abroad. Failing to accurately predict the cost of living in Japan can cause frustration and hardship. Underestimating how costs will change as one reaches milestones such as retirement can have dire consequences.
The most common cost underestimation expats make is the cost of traveling. Most expats, especially those with family back home, will travel internationally more frequently than the average person.
Flights from California to Tokyo can cost around 2000 USD. Imagine travelling back home 3 times per year—that is not cheap. Then add on a spouse and children. Thus, expats should plan to spend a substantial portion of their income on transportation if they like to travel back home.
Another cost underestimation financial advisers see frequently is the cost of healthcare. Underestimating the cost of healthcare is not good.
As people age, they become more likely to need health services. Most people would like to have access to the best healthcare possible. Unfortunately, this comes as a substantial cost. Thus, expats should always make sure they factor the costs of healthcare into their savings and investment decisions.
There are a variety of costs associated with living abroad that tend to blindside Americans in Japan when planning how they invest. Working alongside experienced and qualified financial advisors can help to avoid the common mistakes that lead most people to underestimate future costs of living.
Holding Too Much Cash
Everyone needs a “rainy day fund” and cash for deposits on large purchases such as a home or car. However, too much cash is inefficient and overall, an unwise investment decision.
As mentioned before, the complications of international investment are frustrating for Americans. So much so that some Americans in Japan decide to not invest in local markets. Subsequently, many expats hold far too much cash.
Holding too much cash is bad for several reasons. First, cash accounts yield low returns; the typical cash deposit account in Japan earns an interest rate of less than 1 percent. Building wealth in a lifetime simply isn’t possible with present day cash accounts.
Inflation should be a big concern for those with excessive cash holdings. Cash provides no hedge against inflation. When yields on cash savings accounts are lower than the inflation rate, people are essentially losing spending power by holding cash. Even nations with strong financial intuitions experience crippling inflation, as the United States did during the oil shocks of the 1970s.
The risks of holding excessive amounts of cash go beyond inflation. Currency risk is always a concern, even for those who are sufficiently diversified. Furthermore, as the global economy becomes more connected, nations become increasingly subjected to currency value fluctuations.
A main principle of investment is that one should not put all their eggs in one basket. Most people have heard this saying time and time again. Unfortunately, many people still fail to achieve adequate diversification.
The difficulties associated with living abroad can sometimes cause expats to become lazy. Some, overwhelmed by Japanese financial institutions, will just buy a few popular stocks and forget about them.
While this approach is better than not investing, holding just a few stocks is not ideal. Oftentimes expats will just buy major Japanese tech stocks, then wonder why their portfolio is experiencing high volatility and lagging stock market indexes.
If investing international markets is intimidating, Americans in Japan can seek financial advice. Financial advisers experienced in working with expats can help create an investment portfolio optimized to the specific needs expats have. The ideal portfolio should include a broad basket of stocks, real estate, bonds, and alternative investments.