A Beginner’s Guide to U.S. Taxes for Expats
While living or working abroad, you need to plan to continue filing an annual U.S. tax return. Regardless of any hearsay or unqualified advice you might receive, filing a federal tax return is the only way you can elect to apply the additional tax benefits available to American expats, which for most people means not owing U.S. taxes. Filing also provides you with protections that can help prevent an IRS audit or unnecessary taxes and penalties.
For Americans working overseas, there are income exclusions, additional deductions, and possible tax credits available to you if you meet the qualifying criteria for them. When you understand how all these tax benefits work together for you, you will find that with a little planning you may substantially reduce your tax liability.
As you research the tax benefits of living and working abroad, you will learn a great deal about the Foreign Earned Income Exclusion, the Housing Allowance Exclusion/ Deduction, and Foreign Tax Credits.
Foreign Earned Income Exclusion (FEIE)
This exclusion is the primary tax savings tool for U.S. expats. If you qualify for it, electing the FEIE may allow you to exclude up to $105,900 (for tax year 2019) of your foreign earned income from U.S. taxation. That is earned income of up to $105,900 for tax year 2019 on which you will pay no U.S. income tax. In many circumstances, this exemption may eliminate your U.S. tax liability. However, it does not offset self-employment tax.
To qualify for the exclusion, you need to determine your tax home over a 12-month period. The IRS has established specific tests that define your tax home. You must meet the 330-Day Physical Presence Test or the Bona Fide Residence Test. Remember: Earning less than $105,900 (for tax year 2019) in foreign earned income does not automatically provide you with the exclusion; you must file a U.S. tax return to elect it.
Foreign Housing Exclusion or Deduction
The IRS recognizes that an American working abroad may need to secure housing while away. Like the FEIE, this tax benefit is dependent upon your fulfilling either the 330-Day Physical Presence Test or the Bona Fide Residence Test.
Many employers offer foreign housing to employees that take positions in a foreign country. This could be in the form of a housing allowance, or even full coverage of all housing costs. However, Uncle Sam considers this a form of compensation and your employer must include it in your taxable income. The Foreign Housing Exclusion helps employees reduce the tax sting of including housing compensations as earned income.
Those who move overseas and are self-employed must still pay for some sort of foreign housing. The IRS allows a Foreign Housing Deduction to self-employed individuals abroad as an additional deduction against their foreign income. This deduction does not offset any self-employment tax that may be due, but is still helpful in reducing your overall individual federal income tax liability.
Foreign Tax Credit (FTC)
The Foreign Tax Credit is your tool against double taxation on international income. You are not required to meet the Physical Presence nor the Bona Fide Residence test to utilize this tax credit. For any foreign income tax you pay, you may be eligible for a direct dollar-for-dollar credit against your U.S. tax liability. Any excess can be carried back and carried forward to other years. You cannot claim a credit for foreign taxes paid on amounts excluded from gross income under the Foreign Earned Income Exclusion or the Housing Exclusion.
You must file a tax return to receive these tax benefits
The most common mistake expats make is not filing a U.S. tax return while abroad. Due to a lack of understanding or misinformation, many expats believe they do not have to file a tax return. Rare is the case that a U.S. citizen earning income abroad does not have to file a U.S. tax return while they are away.
However, not filing your U.S. tax return while working or living abroad can cause numerous problems. The IRS can disallow your Foreign Earned Income Exclusion (FEIE), costing you tens of thousands of dollars in unnecessary taxes, penalties, and interest. Even appealing the disallowance can be costly, starting at $3,500 with no guarantee of the outcome.
Penalties and interest accrue from the point of non-filing on any amounts determined due, adding significantly to your tax bill. The accrual of these amounts can substantially increase your original tax bill, by 40%, 50%, or more. The IRS may also decide that your failure to file was also intent to defraud, which puts you in jeopardy of criminal charges.
Tax evasion is generally an unnecessary stress and anxiety for the American expat as there are many legitimate avenues to reducing your U.S. tax bill. The single most valuable tax savings tool for Americans wanting to live and retire abroad is planning. Hasty, fear-based decisions result in some of the most costly tax mistakes of all, mistakes that can affect the rest of your financial life.
You’ve worked hard to get to this place in life. You achieved your career and family goals by planning ahead, making informed decisions, adjusting your plans when life changed, and having clear exit strategies. These same principles can ensure that your life abroad will be everything you dreamed of. Thorough tax planning before you move can result in beneficial tax outcomes after you move.
Written by Katelynn Minott