Now more than ever, people can live and work wherever they choose across the globe, and it’s no wonder it’s such a popular choice. But, the way that people work and live abroad can impact your tax liability. Let’s go over some of the ways that expats can reduce their US tax liability. Keep in mind: a US person includes US citizens and Green Card holders, so the term US person will be used to describe both.
The first thing to know about US taxation for Americans working abroad is that you are subject to US tax on worldwide income regardless of where you live or work. This treatment is known as citizenship-based taxation, so your residence doesn’t matter. From a filing requirement standpoint, there is no difference between a taxpayer living in sunny California or someone living in Switzerland. As an expat, you will prepare Form 1040 annually and perhaps a state return depending on the rules for your state and the connections that you have abroad.
Credits and Exclusions Can Help Expats Can Reduce Their US Tax Liability
While the US does impose a tax on worldwide income for US persons working in a foreign country, two main credits and exclusions are designed to alleviate this burden. The two big ones are the Foreign Earned Income Exclusion and Foreign Tax Credit. These two tax benefits can be used separately or in connection with one another. It is essential to determine the best option for you. Many circumstances come into play, such as your work location, the amount you earn, your family dynamic, other sources of income, and if you are covered by a pension scheme. To claim these benefits, you must have foreign-sourced earnings, meaning the work you did was outside of the US. If you have both US-sourced and foreign-sourced income, then your wages will need to be allocated accordingly.
Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion (FEIE) allows a worker in 2019 to deduct up to $105,900 of earnings, and on top of that, they can claim certain housing costs if they exceed $16,944. The maximum housing cost exclusion is limited to $31,770, but if you live in a high-priced locality, then the amount may get a substantial boost. Housing expenses include rent, utilities (excluding telephone) insurance, nonrefundable cost of obtaining a lease, renting furniture and accessories, and residential parking cost. Property owners can’t include mortgage interest and real estate in the foreign housing allowance.
To qualify for the exclusion, you must have a tax home in a foreign country and meet either the physical presence test or the bona fide residence test. So, let’s assume we have an expat that earned $120,000 working solely abroad and had $33,000 of qualified housing expenses. This expat can exclude the entire $120,000 earned overseas. The exclusion amount would be $105,900 plus $14,100 of foreign housing. The FEIE is limited to foreign wages, so if you make less than exclusion, than the excess amount is lost, meaning that will not reduce any income, including future income. In this straightforward example, our expat paid no income tax. Undoubtedly, the FEIE is a great tax reducer for people living in a country that imposes no or low income tax.
Foreign Tax Credit
The Foreign Tax Credit is appropriate for people that are paying taxes to a foreign country and the foreign rate of tax is equal to or exceeds the US rate. It can also save those with wage earnings that exceed the FEIE when it is used in conjunction with the exclusion. Unlike the exclusion, it isn’t lost if you don’t use all of the tax credit in a year. The credit can be taken back one year to the previous filing or moved forward up to ten years. With the tax credit, there aren’t special rules or timeframes. You need simply to pay tax to a foreign country on income earned there. For example, for an expat that earned a salary of $120,000, the US income tax on this for a single person would be $20,210. If the tax paid abroad exceeds $20,210, then no US tax applies to the earnings. The amount that exceeds $20,210 would be available for the carryback or carryforward. For people with children, the tax credit could allow you to claim a refund from the IRS even when no US tax is paid.
Foreign Pension Plans
Many workers abroad often have foreign pension plans, and these add another level of complexity. Generally speaking, the contributions your employer makes are added to your wages, and the foreign earned income isn’t able to reduce this amount. The amount that you place in the pension scheme doesn’t reduce your income, so while these may be saving you tax abroad, it could be increasing your US liability. A pension scheme that you control is treated as a trust and must be reported on the complex Form 3520. In the eyes of the IRS, control means that the money you contributed is more than your employers.
To further complicate things, where you live has an impact on this. For a person in the UK, the tax treaty adjusts this treatment, and your wages for UK purposes would match US wages. For a person living another country without the benefit of a tax treaty, then US wages would be more. Lets look at our simple example to drive this home. An expat living in the United Kingdom earned € 120,000 and contributed € 5,000 to a pension plan, and the employer contributed € 5,000 to the plan. For UK purposes, their income is € 115,000 since the money invested in the pension reduces income, and the employer funding isn’t considered. For a taxpayer who lives in Singapore, the amount would be different.
Other complexities abound for people with pensions that have earnings over a certain amount. When you retire, your place of retirement and the treatment of the pension will come into play. Having a foreign pension can completely change things, so careful planning is a must.
If you remember only one thing, know that a tax return is usually required even if you won’t owe anything after the FEIE or Foreign Tax Credit. These benefits only apply if you file an income tax return and, in some cases, could be lost if you don’t file a tax return. Working abroad is becoming more common and is exciting, but if you want to keep your passport, you must file your taxes promptly.
Greenback Can Help Expats Can Reduce Their US Tax Liability
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