The Foreign Tax Credit for Digital Nomads Living Abroad
April 23, 2020
If you are a U.S. citizen or resident alien, the rules for filing income tax returns and paying estimated tax are generally the same whether you are in the United States or abroad. Your worldwide income is subject to U.S. income tax, regardless of where you reside. There is a combination of tax benefits and filing requirements associated with living outside the U.S.
This creates tax strategies that could result in huge tax savings.
Foreign Earned Income Exclusion for Digital Nomads
If you are a U.S. citizen or a foreigner residing in the United States and you live abroad like many digital nomads do, you are taxed on your worldwide income. However, you may qualify to exclude your foreign earnings from income up to an amount that is adjusted annually for inflation ($105,900 for 2019, and $107,600 for 2020). As the term implies, foreign earned income exclusion (FEIE) applies to earned income. This usually refers to one’s salary or self-employment income. It does not apply to interest, dividends and capital gains. It should also be noted that the FEIE does not apply to self-employment tax.
One can qualify for the FEIE based upon bona fide residency in a foreign country or countries for an uninterrupted period that includes an entire tax year, or the physical presence test (physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months).
One must fill out Form 2555 to claim the FEIE, but overall it is a simple process and a tax professional will be able to help you make sure it’s accurate.
Foreign Tax Credit
The foreign tax credit is available to anyone who either works in a foreign country or has investment income from a foreign source. The purpose of the tax credit is to avoid double taxation. This is important since U.S. taxpayers are required to report their worldwide income on their U.S. tax returns, even when the source of foreign income has already been taxed in a foreign country. Note that one cannot claim the tax credit on foreign income that was excluded pursuant to the FEIE. If one’s income exceeds the FEIE limit, the foreign tax credit can be claimed on the income that exceeds the limit. The credit is claimed by filling out Form 1116, which is part of Form 1040.
Additional Filing Time
For calendar year taxpayers, the tax filing due date is April 15 of the following year.
However, if you are a U.S. citizen, a foreigner residing overseas, or are in the military on duty outside the U.S., you are entitled to an automatic two-month extension to June 15.
You will not have to pay tax or penalties during this two-month period, but you will have to pay interest on any tax not paid by the regular due date of your return.
Fincen Form 114 (formerly Report of Foreign Bank and Financial Accounts)
This is not specific to U.S. persons living overseas, but such persons who are overseas for an extended period of time are probably more likely to be subject to the filing requirements. A U.S. citizen with a financial interest in or signature or other authority over at least one financial account located outside the U.S. will have to file this form if the aggregate value of those foreign financial accounts exceeds $10,000 at any time during the calendar year. The form, which is separate from one’s tax return, must be filed electronically by April 15 of the following year.
Tax Strategies to Consider When Living Outside the US
Physical Presence Test
As previously mentioned, passing this test is one way to exclude a portion of one’s earned income from U.S. taxable income.
The 330 days do not have to be consecutive, but they must be within a 12-month consecutive period. The tax saving strategy is based upon the fact that the 12 months do not all have to be in the tax year for which a tax return is being filed. For example, an overseas taxpayer might realize on December 31, 2019 that they have only been outside the U.S. for 100 days. It would be permissible to remain outside the U.S. for another 230 days (which is the shortfall) in the year 2020. Thus, they could stay outside the U.S. until August 18, 2020. That date is after the June 15, 2020 due date, so they would file Form 2350.
The purpose of Form 2350 is to ask for an extension to file your tax return if you expect to file Form 2555, and you need the time to meet either the bona fide residence test or the physical presence test to qualify for the FEIE and/or the foreign housing exclusion. In this manner, a taxpayer with high income can save thousands of dollars in taxes by using this strategy.
State Recognition of the FEIE
Excluding one’s income from federal taxation based upon the FEIE does not automatically result in an exclusion at the state level. The following states do not allow the FEIE to be included on the state return: Alabama, California, Hawaii, Massachusetts, New Jersey, and Pennsylvania. Taking steps to change one’s residency from one of these states, preferably to one that does not have income tax, would be a wise tax strategy for a taxpayer who is planning on leaving the U.S.
Tax Gain Harvesting
Taxpayers who are in the two lowest tax brackets (currently 10% and 12%) are exempt from capital gains taxes on long term capital gains and qualified dividends.
Tax gain harvesting refers to selling stocks at a gain when one is in one of these low tax brackets. This strategy is not specific to U.S. persons overseas. However, there are many retired U.S. taxpayers overseas who are largely dependent upon their investment income. If such taxpayers are careful to monitor their stock sales, they could enjoy tax-free income.
Investing in the U.S. when Overseas
Here are two important investment considerations when you are living overseas:
First Consideration
As previously mentioned, the 0% tax rate applies to qualified dividends. These are dividends that have been paid by a U.S. company or a qualifying foreign company. Thus, one could save on taxes by having a portfolio with a sizable portion of U.S. dividend-paying stocks.
Second Consideration
It is common to invest in IRA’s to provide a source of retirement funds in the future. However, caution is advised when one is claiming the FEIE. Income that is excluded from U.S. taxable income pursuant to the FEIE cannot be used to make IRA contributions. Being mindful of this avoids the 6% federal excise tax that could be assessed on ineligible IRA contributions.
What’s Your Next Step to Maximize Your Tax Savings?
Travel Itinerary: The aforementioned Form 2555 is required to claim the FEIE. Claiming the exclusion requires taxpayers to list the dates they were inside and outside the U.S. throughout the tax year. This can be a real challenge for digital nomads who could very well be in a dozen or more locations. It would therefore be best to create a travel itinerary at the beginning of the year and update it periodically.
Claiming Exempt: U.S. taxpayers who do not expect to have a tax liability can claim exempt by filling out Form W-4. A similar option is available for people like digital nomads who do not expect to have a federal tax liability because of the FEIE. The only difference is that such a person would fill out Form 673 (Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911). Filling out this form does not exempt one from self-employment tax on 1099 misc income, so one should consider discussing the form with a tax professional.
Review your Portfolio: As previously mentioned, qualified dividends (paid by U.S. corporations) are taxed at favorable rates. That could mean 0%. From both a tax and investing perspective, one should strike a balance between investing in U.S. securities and investing in foreign ones. The former allows one to benefit from lower tax rates, whereas a blend of the two provides diversification. It is advisable to have a tax professional review your portfolio for tax efficiency.
