For US citizens living overseas, taxes can be complicated. Even worse than all the paperwork is being taxed twice.
If you are a resident of a foreign country and live there for an extended period, you can fall under that country’s tax jurisdiction and be taxed by them in addition to US taxes.
So, how do you avoid double taxation on foreign earned income? Keep reading to find out how to avoid tax on foreign income, avoid double taxation, and save money on your US taxes as a US citizen overseas.
In this article, we’ll be going over:
- US taxes for citizens overseas
- How to avoid double taxation on foreign income
- What is Foreign Tax Credit?
- What qualifies for Foreign Tax Credit?
- How Foreign Tax Credit Works
- Carryover Credit
- How are Foreign Tax Credit and the Foreign Earned Income Exclusion different?
- Which is better: Foreign Tax Credit or Foreign Earned Income Exclusion?
- Can you use both Foreign Tax Credit and Foreign Earned Income Exclusion?
- Foreign Tax Credit for Companies
TAXING US CITIZENS OVERSEAS
If you are an American paying tax and living in another country, are you still obligated to file and pay taxes to the United States?
America is one of the only countries in the world that uses a citizenship-based tax. This means that whether or not you live in the United States, as long as you are a US citizen, you are still subject to pay US tax.
The only way to completely escape US citizenship-based taxation is to leave the US and give up your US citizenship. (Hold on! You don’t have to give up your citizenship right at this exact moment. There are ways to save money on taxes and keep your US citizenship. We’ll talk about a couple in this article.)
So, how does this apply to double taxation?
If you are a US citizen and move to another country for an extended period of time, you are also going to be obligated to pay taxes in that country. We’ve already established that you’ll be obligated to pay US federal income tax because of your US citizenship, so in this scenario, you are going to be taxed by both the US and the foreign country you live in.
Not only are they both trying to tax you, but both countries are going to try and tax you on the same income. Luckily, there are ways to avoid double taxation on foreign income.
HOW TO AVOID DOUBLE TAXATION ON FOREIGN INCOME
As long as you are a US citizen, you can’t get out of filing taxes in the United States, even if you are a tax resident of another country.
So, how do you avoid double taxation of foreign income?
There are a few different tax exemptions and policies that you may be able to qualify for. This is where the Foreign Tax Credit (and the Foreign Earned Income Exclusion) come into play.
WHAT IS FOREIGN TAX CREDIT?
The Foreign Tax Credit (which can be filed under Form 1116) is a tax policy that allows you to use the tax you are paying in another country as a tax credit in the United States so that you don’t have to pay double taxation on the same income.
Form 1116 gives you the option of choosing a deduction or credit, not both. (Although you do have the option to change this from year to year.)
Most often, choosing the tax credit will save you more money than choosing the deduction. If you choose to take a tax credit, the credit will work as a dollar for dollar credit.
A deduction, on the other hand, lowers your taxable income, but you are going to be taxed on the rest at the same percent.
WHAT QUALIFIES FOR FOREIGN TAX CREDIT?
The Foreign Tax Credit only applies to income tax, taxes on war profits, or taxes on excess profits. This only applies to taxes that are imposed on you. You can’t just pick a foreign tax and use it for your foreign tax credit, you actually have to be required to pay those taxes.
If you do not live in another country for an extended period of time (180 days) and instead are jumping from place to place, you are most likely not going to have any foreign taxes imposed on you. If this is the case, you won’t qualify to get the foreign tax credit.
The Foreign Tax Credit does not apply to sales tax, property tax, excise tax, self-employment tax, or gross revenue.
HOW DOES FOREIGN TAX CREDIT WORK?
A foreign tax credit is determined by what income tax you pay to a foreign country. As long as you are paying income tax in another country, you qualify for this credit. But how do these credits work?
If the foreign tax rate is lower than the US tax rate, then you’ll have to pay the difference between the two rates to the US.
For example, let’s say you owe 10% tax on $1,000 in income to the foreign country you live in. You also owe 20% income tax in the United States. The foreign country is expecting you to pay $100 in income tax. Does that mean that you still have to pay $200 in US income tax, for a total of $300 of tax on the same income?
The foreign tax credit allows you to use the $100 paid to the other country as a foreign tax credit. You can then subtract that amount from the US tax amount. $200 – $100 = $100. This means you’ll still owe $100 in US taxes after paying your foreign income tax.
If the foreign tax rate is the same as the US tax rate, you’ll pay income tax in the foreign country and then receive a foreign tax credit to reduce the US tax dollar for dollar. If the rate is the same, your US tax will equal zero.
So, if the foreign country charges 20% on your income of $1,000 and the US also charges 20%, you’ll pay $200 to the foreign country and receive $200 in tax credit that you can use in the US to reduce your US income tax bill to zero.
If the foreign tax rate is higher than the US tax rate, you shouldn’t have to pay any US tax. In fact, for all the money you pay to the other country that is over the US tax rate, you receive an excess foreign tax credit. These excess foreign tax credits can be carried over to other years.
For example, let’s say the foreign country charges 30% on your income of $1,000 and the US charges 20%. In this case, you’ll pay $300 to the foreign country and zero to the US. You’ll then be given a foreign tax credit of the difference. $300 – $200 = $100 foreign tax credit for the following year.
Note: US federal income tax is placed on your net income, but if your foreign income tax is placed on gross income it can still be considered for foreign tax credit. Negotiated amounts that take place on income tax can also count.
As mentioned, if the taxes you paid the other country exceed the US tax, you can carry over the excess to another year. Unused tax credit can be carried forward up to 10 years, or it can also be carried back one year.
Let’s look at an example. Let’s say you paid 30% on income tax on $1,000 to a foreign country in 2019 and the US tax requirement was only 20%. You would have paid $300 in the foreign country. Those $300 would be counted as foreign tax credit and applied to the US tax fee of only $200.
The leftover $100 in taxes could then be carried over in tax credit.
Let’s say you then owe 30% in foreign tax on an income of $1,000 in 2020 but the US tax has increased to 40%. You will pay $300 in foreign income tax, which will then count towards your foreign tax credit.
Using the credit you earned that year would reduce your US tax obligation from $400 to $100. But remember how the previous year you paid $100 more to the foreign country than you owed to the US? You still have that $100 tax credit for up to 10 years and can apply that to your 2020 tax obligation, reducing your US tax to 0.
Carryover credits cannot be used unless you have first used the foreign tax credits from the current year.
If you live in a high-tax country, you’ll earn excess foreign tax credits each year. You’ll be able to use these collected excess foreign tax credits if you then move to a lower tax country. This can’t be the United States, because the foreign tax credits only apply to foreign income.
HOW IS FOREIGN TAX CREDIT DIFFERENT THAN THE FOREIGN EARNED INCOME EXCLUSION?
The United States has a few policies and tax laws that will allow you to reduce your tax payment while living overseas. The Foreign Earned Income Exclusion allows you to exclude a certain amount of money from your tax responsibility, given that you meet all the necessary requirements.
The Foreign Earned Income Exclusion works more like a deduction. You get to exclude the first $107,600 (as of 2020) of foreign earned income from your US income tax. The amount you are able to exclude changes each year and is calculated for inflation.
FOREIGN TAX CREDIT VS FOREIGN EARNED INCOME EXCLUSION
Both the Foreign Tax Credit and Foreign Earned Income Exclusion sound like great deals, but which one is better? This really will depend upon the situation.
How do you qualify for the Foreign Earned Income Exclusion? It’s a bit more complicated than qualifying for the foreign tax credit.
To qualify for the FEIE you need to be considered a bona fide resident of a foreign country or spend 330 days out of a 12 month period outside of the United States. You can find more information on the Foreign Earned Income Exclusion here.
If you are not a tax resident of a foreign country and instead are traveling from place to place as a digital nomad, the FEIE is a great way to avoid foreign income tax. In fact, this strategy may only qualify you for the Foreign Earned Income Exclusion and not for the Foreign Tax Credit.
Remember the Foreign Tax Credit requires that you have a tax imposed on you. If you never stay in one place for a long enough period of time to be taxed, you won’t qualify.
The Foreign Earned Income Exclusion is a great option for anyone with an income under $107,600 (the amount you can exempt in 2020) or whatever the number is that year. If you are traveling and have no other tax obligations to another country, you can technically reduce your income tax to zero.
If you are staying put in one place, you won’t be able to avoid tax on foreign income completely, but you can use the foreign tax credit to avoid double taxation on foreign income.
Really, it comes down to your lifestyle, where you live, and how much money you make.
CAN YOU USE BOTH THE FOREIGN TAX CREDIT AND THE FOREIGN EARNED INCOME EXCLUSION?
You can’t use the Foreign Tax Credit on income that has been excluded through the Foreign Earned Income Exclusion or excluded through the Foreign Housing Exclusion. If your money is already excluded from taxation in the US, you can’t use it to earn excess foreign tax credits.
Sorry, but no double-dipping. If you try to use both of these on the same income, at least one, if not both, will be revoked.
However, you are able to use foreign tax credits for the excess money the Foreign Earned Income Exclusion did not cover. If you’re making well over $100,000, you may be able to have the best of both worlds.
ARE THERE FOREIGN TAX CREDITS FOR COMPANIES?
There are foreign tax credits for companies, but this is completely separate from the foreign tax credits for individuals (Form 1116.) Form 1118 is for the Foreign Tax Credit for companies. Form 1118 allows you to file as a corporation for a foreign tax credit for foreign taxes you paid as a business.
Overall, it’s going to be up to you to decide which policy you want to file for. Both the Foreign Tax Credit and the Foreign Earned Income Exclusion can help you reduce your US taxes.
Knowing how to avoid double taxation on foreign income tax really comes down to a matter of paperwork. If you create a solid holistic tax plan, you will be able to save money on taxes by moving overseas, even if you are a US citizen.
The best way to take advantage of this system is to know the rules. Check out other Tax-Free Citizen articles to learn more ways you can save money on taxes.