Leaving the US behind for the life of a perpetual traveler comes with many benefits. You get to explore new places, experience new cultures, and maybe eventually find a new place to call home where you feel you fit.
Did you know that another benefit of living overseas is that you can save on your taxes?
While you still have to pay taxes, there are exemptions that allow you to deduct a significant amount of money from your US tax bill. Not only do you get to live a global life, but you can save money doing it.
Sadly, you are still going to have to file your tax forms. Because the United States has a citizenship-based tax, even if you move overseas you are still subject to pay and file taxes in the US.
Unless you renounce your US citizenship, there’s really no way to completely get out of it.
However, if you are living and doing your business overseas, you may qualify for some legal tax reductions. As you keep reading, you’ll learn how this works.
In this article, you’ll learn about the
- What is the Foreign Earned Income Exclusion (FEIE)?
- What counts toward the exemption?
- Does FEIE affect retirement plans?
- How do you qualify for FEIE?
- What is the physical presence test?
- What is the bona fide residence test?
- What is the substantial presence test?
- Do expats need to file tax returns?
- How can you claim the Foreign Earned Income Exclusion
WHAT IS THE FOREIGN EARNED INCOME EXCLUSION?
The Foreign Earned Income Exclusion allows US citizens who live abroad to exclude part of their active income from their federal income tax. The amount changes yearly, but as of 2020 the first $107,600 can be excluded.
Money over that $107,600 is still subject to federal tax.
For example, if you earned $100,000 this year that puts you in the 24% tax bracket. This means you owe $24,000 in taxes to the US government, even though you are living overseas.
By claiming the exclusion, that $100,000 in income isn’t going to be taxed because it is less than the max amount you can exclude through FEIE, and you can save $24,000.
The FEIE applies to federal tax. The exemption does not apply to state or city taxes. Certain states offer the same exemption that the FEIE does, but there are five states that don’t.
You can resolve this issue by moving to a zero-tax state before you go offshore.
WHAT COUNTS FOR THE FOREIGN EARNED INCOME EXEMPTION?
The exemption only applies to active income – money you’re earning from your job or business. Passive income is not exempt. This would be money you make from things like stock trading, trading in cryptocurrency, or selling real estate. (Though there are some exceptions if your profession includes flipping houses, etc.)
The FEIE applies per person, meaning if you are married, you and your partner can get an exclusion of over $200,000 total, so long as you are both working.
In addition to the exemption of your first $107,600, the FEIE gives you a foreign housing credit. You can exclude whatever you paid over 16% of the FEIE. As of 2020, 16% of the FEIE limit is $17,216.
For people who are making seven or eight figures a year, this exclusion might not seem like much. But it’s probably the best tax break you’re going to get if you remain a US citizen.
The exempted money is still counted when determining your tax bracket. Your tax bracket is determined by your total income. You have to count it all and cannot subtract the $107,600 exemption from your total income when figuring out which tax bracket you are in.
For example, if your income in 2020 was $200,000, you cannot subtract the $107,600 exemption from that income and say that you only have an income of $92,400, which would put you in the 24% tax bracket. Your income is still $200,000, which falls under the 32% tax bracket.
The benefit of the FEIE is that you only have to pay 32% in taxes on the amount over $107,600. In this case, you still have $92,400 of income that is over the exemption amount, so you will pay 32% of that in taxes for a total income tax bill of $29,568. If you had to pay 32% of the full $200,000 your total tax bill would be $64,000!.
In addition to this, you are still required to pay taxes to whatever country you live in for a long enough time to be a tax resident.
There are cases where you won’t have to pay the US, so long as the taxes you are already paying to the country you expatriated to are as much or more than what you would be paying the US.
If you are self-employed, your income is excluded, but you are still required to pay self-employment tax, such as Social Security.
The self-employment tax is applied to your net profit, including the money exempt from the federal income tax through FEIE.
As of 2020, the self-employment tax rate is 12.4% for Social Security and 2.9% for Medicare. This self-employment tax rate of 15.3% applies to up to $137,700 in income. And the 2.9% Medicare tax applies to all of your earned income, if you earn less than $200,000. If you are earning over $200,000 the Medicare tax goes up.
If you are self-employed and earning $100,000 a year, you can have all of that exempted from federal income tax through the FEIE. However, you are still going to have to pay that 15.3% on self-employment tax for a total tax bill of $15,300.
You can avoid having to pay self-employment tax by establishing a foreign company. Foreign employees don’t have to pay Social Security tax or Medicare tax. So, if you create a foreign company, you can hire yourself as an employee and then you will be considered a foreign employee for tax purposes rather than self-employed.
WILL CLAIMING THE FOREIGN EARNED INCOME EXEMPTION AFFECT MY RETIREMENT PLANS?
Going offshore may affect your retirement plans if you were counting on Social Security. Getting out of the Social Security tax means you’re not going to have access to Social Security later on. If you don’t pay for Social Security while you’re offshore, it’s not going to be there for you when you retire.
I wouldn’t freak out over this. There are many other options for retirement in the world. Consider looking into different investments you can make today that can take care of you in the future.
An investment in foreign real estate if done right can be rented out to provide you with money you can retire with.
And many foreign banks have higher interest rates than the US. Put your money in a bank in an emerging company with a high interest rate and you will earn money just by keeping your money there.
DO I QUALIFY FOR THE FOREIGN EARNED INCOME EXCLUSION?
There are three requirements to qualify for FEIE:
#1: have a tax home outside of the US,
#2: have foreign earned income, and
#3: pass either the Physical Presence Test or the Bona Fide Residence Test
FOREIGN TAX HOME
A tax home is not the same thing as a tax residence. What can qualify as a tax home can be where your business is located, where you are employed, or your post of duty so long as it is outside of the United States.
However, the most important part of establishing a tax home is for you to physically be outside of the United States. You cannot set up a business offshore and continue to live in the US and expect to claim the Foreign Earned Income Exclusion.
You need to be physically outside of the United States to declare that you have a foreign tax home.
FOREIGN EARNED INCOME
The second thing you need to qualify for the FEIE is foreign income. This makes sense, seeing as it is foreign income that the exemption covers.
If you are earning an active income outside of the United States, that money is going to help you qualify for the tax exemption.
So long as you have a solid foreign connection for your tax home and are earning income outside of the US, you’ve passed the first two requirements to qualify for the FEIE.
The third requirement is the trickiest, so we’re going to break that up into a few parts below.
WHAT IS THE PHYSICAL PRESENCE TEST?
The Physical Presence test is pretty straightforward. You pass the physical presence test if you spend 330 days out a 365 day period outside of the United States.
You can spend those 330+ days in whatever country or countries that you want, (excluding a few places such as Cuba, North Korea, and Antarctica).
Feel free to travel to your heart’s content.
But if you spend 36 days in the US (or on international waters, which doesn’t count as foreign territory), you no longer qualify.
WHAT IS THE BONA FIDE RESIDENCE TEST?
The Bona Fide residence test requires you to claim a new country as your tax home for at least a calendar year and to be a tax resident of that country for over a year. To claim a country as your tax home, you need either a long-term residence or permanent residence permit. You also must be intending to permanently leave the US.
The Bona Fide Residence Test also requires that you be able to prove your ties to your tax home country, should the IRS come asking.
Through the Bona Fide residency test, you can technically spend more time in the US than you could by using the Physical Presence Test (so long as you are spending less than 120 days each year – spending too much time in the US will trigger the Substantial Presence Test.) However, it’s a lot harder to pass the bona fide residence test.
That said, you shouldn’t worry too much about getting a tax residency in another country. It’s fairly easy to do.
You can obtain a tax residency by paying for it – this might mean opening a bank account in the country or investing in real estate. Some countries have time requirements, meaning you must spend a certain number of days or months in the country in order to qualify as a tax resident.
Whatever the case may be, you do have to spend time in the country you are claiming as your new tax home. The bona fide residence test assumes that you are spending the majority of your time in your tax home country.
WHAT IS THE SUBSTANTIAL PRESENCE TEST?
In short, the Substantial Presence Test is how the IRS determines if they can tax foreigners and/or expats who have established a bona fide residence in another country.
The rules for this text are a bit complex. In general, you are counted as a tax resident in the US if you’ve spent 183 days out of the last three years in the US.
However, the days are weighted differently each year.
1 day this year = 1 day
1 day last year = ⅓ day
1 day two years ago = ⅙ day
So, if you spent 12 days in the US two years ago, that counts as 2 days. And if you spent 12 days in the US last year, that counts as 4 days. And if you spent 12 days in the US this year, that counts as 12 days. Total, this would count as you spending 36 days in the US over the last 3 years, which is less than 183, so you pass the test.
In fact, you could technically spend another 146 days in the US during the three-year cycle and still pass. However, based on how all the math works, it works out that you should only spend an average of 120 days or less in the US each year if you want to continue to pass the test.
This test counts toward everyone spending time in the US, with exceptions for Canadian and Mexican citizens who commute to the US to work.
IF I QUALIFY FOR THE FOREIGN EARNED INCOME EXEMPTION DO I STILL HAVE TO FILE A TAX RETURN?
If you claim the FEIE, you still have to pay taxes and you still have to fill out your tax forms. The FEIE is not automatically applied. In order to use this exemption, you have to claim it on your tax return.
If you are a US citizen, you always have to fill out your tax return. It doesn’t matter if you don’t live there. It doesn’t matter if you’re paying little to no taxes. It doesn’t matter if you pay your taxes to a different country.
You have to fill out your US tax return.
If you are earning less than the $107,600, you won’t have any federal income tax. But you still have to turn in your paperwork to the IRS.
You are required to report all income, foreign bank accounts, and all companies. And you’re still required to pay any taxes due that weren’t exempted.
WHAT FORM DO I FILE TO CLAIM THE FOREIGN EARNED INCOME EXEMPTION?
To claim the FEIE, you have to file Form 2555.
In addition to your general information, the form needs you to show in what ways you pass the FEIE qualifying tests mentioned earlier in the article. They also need a report on your total foreign earned income. And you need to include any other deductions that you’re claiming.
Thanks to the Foreign Earned Income Exclusion, by becoming a digital nomad, you are already reducing your taxes. While the United States is always going to have some claim over you so long as you are a US citizen, the FEIE is going to free up a relatively good-sized portion of your income.
Just think of all you can do with the money you save. It makes the hassle of filing your tax return worth it. But remember that you do need to file and report. Don’t make the same mistake other digital nomads have made and think that you can simply go overseas and be free of all tax and filing responsibilities.
So long as you are doing everything legally, feel free to keep traveling and save money on taxes as you do.