An expatriate or expat is someone who lives outside their native country for any reason. They may have decided to work in a different country, retire and travel internationally, or move closer to family. For people living abroad, taxes can be a major concern. There are ways to optimize your tax strategy and structure your income so that you can live your life internationally and not worry about additional tax stresses.
Let’s use Lisa as an example in this article. Lisa is a U.S. citizen and has decided to take a job working in London.
Avoiding Double Taxation in Cross-Border Planning
It might seem unfair, but the United States taxes its citizens and permanent residents on their worldwide income. This means all your income is subject to U.S. taxes even if earned or received in a foreign country. Lisa’s salary would be taxable in the U.S. even though it was earned in the United Kingdom. Any other income she received while living in England would also be taxable in the U.S. Some examples include interest, pensions, dividends, rental income, and capital gains.
Many countries outside of the U.S. also have income taxes. Does this mean having to pay taxes in both the US and a foreign country?
Lisa will probably need to file a tax return and report her income in both the US and the United Kingdom. Fortunately, the U.S. has some provisions that help offset taxes paid in a foreign country. The most used of these provisions include the foreign earned income exclusion (FEIE) and the foreign tax credit (FTC). We’ll cover the basics of these provisions below.
Foreign Earned Income Exclusion (FEIE)
The Foreign Earned Income Exclusion (FEIE) provision is a way to exclude foreign-earned income on your US income tax return of up to a certain amount. For 2023, the amount is $120,000 and adjusts for inflation each year. The IRS assumes you will be taxed in the country where you are currently living on your foreign-earned income and allows you to avoid double taxation by granting this exclusion.
It’s important to note this exclusion only applies to earned income such as wages or self-employment income. The provision doesn’t apply to passive or investment income, such as interest income or pension income.
Let’s assume Lisa’s wages (paid in pounds) were equivalent to $110,000. This essentially means Lisa could exclude her entire salary from U.S. taxation and only be taxed in the United Kingdom.
There are a few tests you need to meet to qualify for the FEIE. You need to meet either the physical presence test or the bona fide residence test. Both tests require that you have a foreign-earned income and maintain a tax home in a foreign country.
1. The physical presence test requires you to be present in a foreign country for at least 330 days in a 12-month period.
2. The bona fide residence test requires that you be a bona fide resident of a foreign country. What does that mean? This can be shown by having documentation indicating you have made the foreign country your permanent residence. Examples include owning or leasing a home, opening a bank account in a foreign country, utility bills, etc.
If you meet at least one of these tests, then you would file Form 2555 as part of your U.S. tax return to claim the income exclusion. If you qualify for the FEIE then you may also qualify for the foreign housing exclusion. This allows you to reduce your U.S. income taxes by claiming some of your qualified foreign housing expenses.
You can use the IRS’s Interactive Tax Assistant tool to help determine whether income earned in a foreign country is eligible to be excluded from income reported on your U.S. federal income tax return.
Foreign Tax Credit (FTC)
The Foreign Tax Credit (FTC) provision allows you to reduce your U.S. income taxes dollar for dollar (a tax credit) by the amount of income taxes you paid to a foreign country. Let’s say Lisa paid $10,000 equivalent in taxes to the United Kingdom. She could then reduce her U.S. income taxes by $10,000 by claiming the FTC.
You need to meet a few criteria to be eligible for the FTC. You need to be a U.S. citizen or permanent resident, have foreign income, and pay income taxes on that income to a foreign government. It’s important to note the FTC applies to all foreign source income and not just earned income. In other words, you can claim the FTC on investment and passive income, in addition to wage or self-employment income. You generally claim the FTC by completing Form 1116 as part of your U.S. income tax return.
You can use both the FEIE and FTC on your U.S. income tax return if you qualify for both provisions but not on the same income. For example, Lisa wouldn’t be able to exclude her wages using the FEIE and get the FTC on the same wage income. She would need to choose between the two methods. Lisa could use the FEIE on her wage income and the FTC on other income such as interest or dividend income received while she was living abroad.Tax Tip from Mission Wealth: The FTC is generally a better option in countries that are more heavily taxed whereas the FEIE may be better in low or no tax countries. Having said that every situation is unique, and you should seek out guidance from a qualified professional to determine the best option for you.Click To Tweet
Foreign Bank Accounts and Assets
There are two other potential tax filings to be aware of. The first filing is called the Foreign Bank Account Report or FBAR. This requirement generally applies if you have foreign holdings of $10,000 or more at any point during the year.
For example, let’s say Lisa opened a bank account in England. She had $12,000 equivalent in the account on June 15th but only $8,000 equivalent at year-end. Since the account had more than $10,000 at any point during the year, Lisa would be required to file an FBAR.
The filing requirement can apply even if you only have signatory authority over a foreign bank account. A potential “gotcha” would be if you have signatory authority on your employer’s foreign bank account or are an officer of an association with a foreign bank account. You would still be required to file this form.
This filing is done on FinCen Form 114 and is filed electronically with the Department of Treasury. It is filed separately from your U.S. income tax return.
The second is called the Foreign Account Tax Compliance Act or FATCA. This applies when you have foreign assets exceeding various limits. These limits vary depending on your filing status and whether you are living in the US or abroad. If applicable, you would complete Form 8938 as part of your U.S. income tax return.
The penalties for not filing these forms can be severe, so it’s important to be aware of them.
Cross-Border Tax and Financial Planning Services
U.S. taxation issues surrounding expats can be complicated. At Mission Wealth, we partner with a team of seasoned professionals with a deep understanding of cross-border tax planning. Our multidisciplinary approach combines tax advisors, legal experts, financial planners, immigration specialists, and investment professionals, collaborating to tailor comprehensive strategies to our clients’ unique needs.
We empower our clients and their families to expand their reach, maximize opportunities, and navigate international frontiers with confidence.
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