Many Americans are considering moving abroad to take advantage of professional and personal opportunities in a global economy. But as a U.S. citizen living in a foreign country, your tax situation may become more complex, especially because the U.S. requires all of its citizens and green card holders living abroad to continue to file returns in the U.S., and pay taxes on their worldwide income. Depending on the source and level of your income, however, you may be entitled to a number of tax breaks, chiefly designed to keep you from being taxed doubly by your adopted country, as well as in the United States. Whether you actually come out ahead on taxes will depend on which country you work in and its tax rates, along with your individual financial and employment situations.
When you are filing your U.S. return while living in a foreign country, any salaries, wages, and bonuses that you earn abroad, but not investment income and capital gains, qualify for the $107,600 exclusion in 2020. Whatever income you collect beyond the $107,600 is combined with your other taxable income, such as interest, dividends, and rental income, and is subject to taxation. However, foreign taxes paid on income in excess of the exclusion can be taken as a credit or a deduction. Many Americans living overseas may be better off taking the credit, because they are no longer entitled to all of their previous write-offs and are unable to itemize deductions.
You can also forgo the $107,600 exclusion and apply the foreign tax credit to your entire income. Some accounting professionals suggest this may make sense in high-tax countries where top tax rates exceed those of the U.S. They also recommend that you run the numbers both with and without the exclusion before you file.
There is also an exclusion that compensates you for the high cost of foreign housing. To calculate this exclusion, add up your annual rent, insurance, and utilities, and then exclude the amount in excess of 16% of the total foreign earned income exclusion. For 2020, this means you may exclude amounts exceeding $17,216 up limits that vary by location. However, the only housing expenses eligible for the foreign housing exclusion are the expenses paid with employer-provided amounts, such as wages, salaries, and tax equalization payments by your employer. If you are a self-employed American living overseas, you cannot take the foreign housing exclusion, but you can claim the foreign housing deduction. To qualify for all of these exclusions and credits, you must be able to meet either the “bona fide residence” or the “physical presence” test, which require you to demonstrate that you have established a residence abroad, or have been physically present in the country for a certain number of days.
Even if you owe no taxes in the U.S., you are required to file a 1040 return with the IRS each year, using Form 2555 to report your foreign earned income. The IRS grants U.S. citizens and resident aliens an automatic two-month extension for filing their returns and paying any amounts due. Thus, the deadline for filing and paying your U.S. taxes while abroad is generally June 15. In addition, U.S. citizens who own a foreign bank account, brokerage account, mutual fund, unit trust, or other financial account are required to file a Form TD F 90-22.1 Report of Foreign Bank and Financial Authority (FBAR) with the IRS, if the taxpayer has a financial interest in, signature authority, or other authority over one or more of these accounts; and if the total value of all the foreign financial accounts exceeds $10,000 at any time during the calendar year. The FBAR is due by June 30 of the year following the year that the account holder meets the $10,000 threshold.
Many accounting professionals suggest there are some potential challenges for Americans living abroad who have most of their investments in the United States. One drawback is that income normally exempt from taxation in the U.S. does not necessarily escape taxation abroad. For example, the interest from certain municipal bonds may be tax free in the United States, but in some countries you may pay more than 50% on those earnings.
The best strategy is to do your tax planning with a qualified tax professional before you make the commitment to live and work outside of the United States. Depending on your individual employment situation and income sources, and on the tax regime in the country in which you plan to live, living abroad can have financial advantages or disadvantages. Doing your “homework” can pay off when you’re contemplating leaving home to work abroad.