Living the life of a U.S. expat has many advantages but dealing with the U.S. tax system is not one of them. Unfortunately, while the whole tax situation can be confusing under the best of circumstances, in an international context it can be downright confounding. Below are 5 U.S. tax traps for the U.S. expats.
1. You need to file
The U.S. imposes taxes on worldwide income on U.S. citizens and its residents, regardless of where in the world they live. Back in the U.S. some people below certain income thresholds can choose not to file. These thresholds are generally linked to the standard deduction. For example, a married couple both over 65 filing a joint return with income is less than $27,400 (USD) (for 2020), might decide not to file. However, regardless of the amount of earnings certain types of income, such as income from self-employment, require you to file a U.S. tax return. Also, if you do not file, you will not get reimbursement of refundable credits. There also exist informative returns, such as the Foreign Bank Account Report(FBAR), known as FinCEN114. Under certain circumstances you must file these whether or not you have taxable income. The penalty for not filing the FBAR is $10,000 (USD) per account, per year.
Suggestion: Regardless of income, file a U.S. tax return every year.
2. Either a Foreign Earned Income Exclusion(FEIE) or a Tax Credit
I once had a prospect from Dallas come into my Mexico office who simply wanted to confirm that by moving to Mexico, he would legally escape all U.S. tax on his income. I asked why he thought this was true, and he told me that he discovered this thing called a “Foreign Earned Income Exclusion”(FEIE) that would eliminate all his U.S. obligations up to $100,000 (USD)! When I asked of what his income consisted, it turned out to be primarily all U.S. sourced interest, dividends, Social Security, and required minimum distributions. When I explained the FEIE can exclude US $107,600 (USD) (2020) but that it applies only for FOREIGN and EARNED income, you could read the disappointment on his face. He moved back to Texas that month!
An alternative to filling form 2555 to get the FEIE is to use the foreign tax credit to lower or eliminate U.S. tax liability, by filling Form 1116. It might be more advantageous to use the tax credit if you plan to make contributions to U.S. retirement plans since excluded income is not eligible for contributions.
Suggestion: Run the tax return using the FEIE and then run the tax credits separately to see which has the best results in light of your situation and goals.
3. No Unlimited Marital Gifting
U.S. citizen spouses enjoy what is called an unlimited marital gifting. The effect is that spouses can gift each other an unlimited amount of assets. If one of the spouses is not a U.S. citizen, they cannot receive more than $157,000 (USD) a year in gifts from the U.S. spouse without incurring a U.S. gift tax obligation. A typical situation where a gift occurs is when title is taken jointly to real property and the U.S. citizen spouse paid for the entire home.
Also, at death, normally the survivor receives the descendant’s assets without having to pay an estate tax. However, the unlimited marital estate deduction only works for U.S. citizen spouses. To the extent that the estate passing to the non-citizen surviving spouse is above the federal estate-tax exemption amount ( $11.58 million (USD) in 2020), the U.S. non spouse would need to pay up to 40% of the value of the assets passing to him or her.
Suggestion: If you have a foreign spouse be mindful of the gift limits and incorporate Qualified Domestic Trust (QDOT) provisions in your U.S. estate plan.
4. Take a look at U.S. Retirement Plans
If you have earned income abroad subject to U.S. tax you are still able to fund U.S. retirement plans such as Traditional IRAs, Roths, SEPs, Solo 401(k)s or Solo Roth 401(k)s. The plan that is right for you will depend on if you are self-employed and other factors. Note also contributions have to be made only from unexcluded income (see FEIE above). Some U.S. custodians will be loath to open retirement accounts for non-residents of the U.S. whereas other custodians will be happy for the business.
Suggestions: Consider the home country implications of investing in the U.S. and if it makes sense, open and fund U.S. retirement accounts.
5. When it comes to foreign mutual funds, don’t go there.
The IRS considers foreign companies that invest mostly for passive income as “PFICs”. Passive Foreign Investment Companies. Expats most typically come across these when they invest in foreign mutual funds. Foreign mutual funds often are attractive because they pay higher rates of return than funds back home. These should be avoided at all costs. If you do happen to have them, you need to report these to the IRS using form 8621. You will find the form a difficult to fill out and the taxes to be paid will likely be onerous. In addition, if you have more than $50,000 (USD) invested in certain foreign assets, including foreign mutual funds, you may also need to file form 8938, Statement of Specified Foreign Financial Assets.
Suggestion: Avoid foreign mutual funds at all costs.
Given the complexity of being U.S. tax compliant when living abroad it is best to hire an experienced professional with international experience to help with your tax compliance issues.