At BNC Tax, one of the most common questions our clients ask us is, “Do I have to pay U.S. taxes if I live abroad?” And the answer is… maybe. A lot of expats ask us about the foreign earned income exclusion, so we will explain everything you need to know in this article.
The United States is one of only two countries in the world with citizen-based taxation, the other country being Eritrea. This means U.S. citizens must file a tax return each year, no matter where in the world they live.
Citizen-based taxation means U.S. citizens living abroad have a tax obligation to the United States. However, there are certain credits and exclusions available depending on your specific circumstances.
Income tax on earned income from working or self employment is the biggest piece of your U.S. tax obligation. If you live outside of the U.S., you might be able to take advantage of tax credits and exclusions on earned income, which can reduce or eliminate the payments you will need to make to the IRS.
There are two important tax credits that Americans living abroad may be eligible for: the foreign tax credit and the foreign earned income exclusion.
In this post we will discuss the differences between the two, and how to take advantage of each one.
First, we will quickly define the foreign tax credit. Then we will examine the foreign earned income exclusion, how to qualify for it, and why people find it so attractive. Finally, we will circle back around to the foreign tax credit, and explain some of its benefits and why our firm prefers to use this whenever possible.
Foreign Tax Credit – IRS Form 1116
When you live abroad, your first tax obligation is to the country where you live. If you pay income tax in that country, you can take the foreign tax credit on your U.S. taxes.
The foreign tax credit is a dollar-for-dollar credit. For every dollar of income tax that you pay to the country you live in, you get one dollar of credit on your United States taxes to counter that U.S. income tax.
The credit is proportional to your foreign sourced income. If you have U.S. sourced income while living abroad, it will cut into your foreign tax credit availability.
Foreign Earned Income Exclusion (FEIE) – IRS Form 2555
If you don’t pay enough income tax in the country where you live to cover your U.S. tax obligation, then you could opt for the foreign earned income exclusion (FEIE).
By claiming the foreign earned income exclusion, single filers can exclude up to $107,600 USD of earned income from taxation, and married couples filing jointly can exclude up to $215,200 USD on their joint return. (These are the amounts in 2020; they are adjusted annually for inflation.)
The exclusion only applies to earned income. Earned income is income from employment or self employment; it does not include capital gains, interest and dividends. You will still be responsible for paying U.S. tax on capital gains, dividends, rents, royalties, and passive income no matter where you live.
It’s important to note that this income is not excluded from reporting, but it can be excluded from taxability. It’s a common misconception that people who make less than $107,600 don’t have to file a tax return at all. The foreign earned income exclusion is an election on a “timely-filed tax return.” This means you must file a tax return and claim the exclusion on the return. Living abroad does not make you exempt from filing, and in fact if you don’t file, you could end up with steep penalty and interest fines. So it’s much better to go ahead and file, and claim this exclusion if you qualify.
If you want to use the foreign earned income exclusion, you must meet specific qualifications.
Physical Presence Test
To meet the physical presence test, you must be physically present in a foreign country or countries for at least 330 full days during a 12-month period including some part of the year at issue. You can count days you spent abroad for any reason, so long as your tax home is in a foreign country.
You do not meet the physical presence test if you are not present in a foreign country or countries for at least 330 full days in a 12-month period regardless of the reason for the failure, including illness, family problems, a vacation, or your employer’s orders. Also, if you are present in a foreign country in violation of U.S. law, you will not be treated as physically present in a foreign country while you were in violation of the law. Income that you earn from sources within such a country for services performed during a period of violation does not qualify as foreign earned income.
Bona Fide Residence Test
The second qualification is the bona fide residence test, which is harder to meet, but once you have it, it’s easier to continue filing through this qualification.
To pass the bona fide residence test, you must live abroad for a full calendar year – January 1st to December 31st.
You must also prove that you’ve moved your life abroad, based on facts and circumstances such as where you live, your social connections, your bank accounts and other connections that you have to your new country.
After the period of one calendar year living abroad, you become a bona fide resident. So in your second year living abroad, you can qualify as a bona fide resident, which means you can use the foreign earned income exclusion for that year and for future years.
Once you become a bona fide resident of a foreign country, you can go back to the United States for more than the 35 day limit and still qualify for the foreign earned income exclusion.
However, you need to be careful, because if you go back to the United States for 4 months, you’ll be considered a resident of the United States again for tax purposes.
There are some exceptions, for example if you have to go back for medical treatment. But essentially the tests that you need to meet in order to qualify for the foreign earned income exclusion revolve around being outside of the United States for 330 days or living a full calendar year abroad.
$107,600 USD Earned Income Cap
The $107,600 USD earned income cap applies to everyone who is taking the foreign earned income exclusion.
The cap means that if you make a salary or self employment income of less than $107,600 you can exclude all of your income as long as you qualify for the foreign earned income exclusion.
If you make a salary or self employment income of more than $107,600, you can exclude $107,600 of your salary.
If you’re in a high income bracket, for example making $250,000 per year, you can use the foreign earned income exclusion combined with the foreign tax credit. You can exclude $107,600 with the foreign earned income exclusion, but you’ll still have taxability on the remaining $142,400. So you can also take the foreign tax credit for the income tax you paid on the remaining $142,400 in the country where you live. By using a combination of the two, hopefully you will have enough credit to offset any obligation to the United States.
In some cases, people do not have enough credit to cover their remaining tax obligation to the United States. For example if you are in a lower tax bracket in your new country than you are in the United States, you’ll end up paying the difference to the U.S.
Why We Prefer to Use the Foreign Tax Credit
Everyone likes the idea of $107,600 of income being excluded from taxation, but our firm actually prefers to use the foreign tax credit whenever possible for several reasons.
First of all, the foreign tax credit is easier to qualify for. You don’t have to meet the physical presence test or the bona fide residence test; you don’t have to stay out of the country for so long. You can just take the amount of income tax that you paid to your new country dollar-for-dollar to reduce what you owe to the U.S. By doing that, in a lot of cases, our clients don’t owe anything to the U.S. People who don’t meet the qualifications for the foreign earned income exclusion have the option to take the foreign tax credit.
Another reason we like to use the foreign tax credit is because foreign tax credits carry forward. You can carry them forward for up to 10 years. This is especially useful for expats and digital nomads. If you live in a country with high income tax for a while, but then you move to a lower tax country in the future, you could end up with a surplus of foreign tax credits carried forward from your years of living in a high tax country to apply to your new situation in your new low tax country.
Foreign tax credits also carry forward if you move back to the U.S. They will carry forward for 10 years no matter where you live, whether in the U.S. or anywhere else in the world.
If you use the foreign earned income exclusion, you throw away the tax credits that were assigned to that piece of income. So if your income is lower than $107,600 and you exclude all of it, you also exclude all of those credits. You don’t get to take any of them, and you don’t get to carry them forward.
Another reason to use foreign tax credit is because when you choose the foreign earned income exclusion, you are entering that program and you must continue claiming the foreign earned income credit for 5 years. You can’t toggle back and forth between FTC and FEIE year by year.
Foreign Tax Credit and Child Tax Credit
Another reason to use the foreign tax credit over the foreign earned income exclusion is if you have kids.
If you have kids, you may qualify for the child tax credit of up to $2,000 per child in 2020. (Up to $1,400 is refundable, but the credit is for up to $2,000 of tax.)
You can qualify for the child tax credit even if you don’t pay U.S. tax. As long as you have earned income over $3,000, you can claim this credit.
If you use the foreign earned income exclusion and exclude all your income, you don’t have earned income anymore, so you lose the child tax credit.
These are some reasons why it’s a good idea to have a tax advisor look at your personal situation to determine what’s going to be best for you, and also think about the future and do some tax planning for you.
Local Tax Withholding Can’t Be Counted for Foreign Tax Credit
The foreign tax credit is for income tax only, as it relates to your earned income. For example, taxes withheld from your paycheck to cover local national health insurance do not count for the foreign tax credit. You have to calculate which part is income tax paid versus national tax premiums.
Foreign Tax Credit and Passive Income
There are many types of foreign tax credits. The two most common are general foreign tax credits for income taxes, and the other is on passive income, i.e. capital gains.
If you have foreign investments, and foreign taxes are being withheld from the gains on those investments, then when you sell the asset you can use the foreign tax credit to take a dollar-for-dollar reduction on the capital gains tax that you would otherwise pay to the United States.
If you live in the Netherlands and you pay Wealth Tax, you’re getting some capital gains foreign tax credit to carry forward to use in the future.
The foreign tax credit on capital gains is only applicable if you sell assets while you’re living abroad.
If you move back to the U.S. and sell your stocks, you can’t use foreign tax credits, because the capital gains are no longer considered foreign-sourced income. The gains are only going to be foreign-sourced income while you’re living abroad. So if you’re thinking about selling some assets while you’re living abroad, you can use the foreign tax credit to offset your tax obligation on those capital gains.
Totalization Agreements and Self-employment Tax
The foreign earned income exclusion and foreign tax credits do not exempt you from paying Social Security and Medicare tax on your income. Unless you live in a country with a “totalization agreement” in which you pay social insurance tax to the country of residence, you should still plan to pay into the U.S. system. If you live in a country with a totalization agreement, you are not subject to Social Security and Medicare tax in the United States, but do need to follow the rules laid out by the Social Security Administration to document your exemption.
You can find the list of applicable treaty countries on the SSA International website: https://www.ssa.gov/international/agreements_overview.html.
Some planning can help you avoid unintended consequences of choosing one exclusion method over the other. Factors to consider:
- Contributions to an IRA / Roth IRA
- Rebalancing portfolios held in taxable brokerage accounts
- Future plans to move to a different foreign country
- Revocation of the FEIE
- Missing the deadline to make the election
- Changes to your tax situation, such as starting a company
- Marriage or divorce
- Family planning
- Purchasing or selling a home
Be sure to discuss your decisions with your tax advisor before you make them! Planning ahead can help you avoid a tax headache later. Your tax advisor has your future best interest in mind. Get in touch with one of our specialists to discuss how to optimize the foreign tax credit and foreign earned income exclusion.