For American Expats – Eight US Tax Saving Tips to Come Out Ahead over the Long Run
This article is for general informational purposes only and is not intended as specific tax advice. Please consult your tax advisor for advice relevant to your situation.
With all the additional tax filing forms and reporting requirements that FATCA has brought, for Americans living overseas sometimes merely filing their US tax return seems like achievement enough. Yet, there are real financial benefits for going beyond merely filing tax forms and instead spending some time figuring out ways that you can save on tax – both in the current year, but perhaps more importantly, over the long-run. After all, for many of us taxes will be the one of the largest expenses we face in our lifetime, and especially so in retirement. If done well, long-term tax planning, or taking the time to ensure you’re as tax efficient as possible, can really pay off.
- If you have a foreign spouse, choose carefully which tax filing status to use. Expat Americans with spouses who are neither US citizens nor green card holders have a choice of US tax filing status. The options include either married filing jointly (MFJ), married filing separately (MFS), or head of household (HOH) if you have children. Many expat Americans in this situation don’t spend much time deciding which filing status is best for them. Yet the U.S. tax filing status chosen may make a big difference on how much U.S. tax you pay, both in the current year and over the long-run. There pros and cons for either filing choice and what makes the most sense is highly dependent on your specific situation. Therefore, it's important to carefully weigh your options carefully – see American Expats with Foreign Spouses: Choosing Your U.S. Tax Filing Status for more detail.
- Be sure to file the correct forms. Most of us have heard of Form 2555 (Foreign Earned Income), Form 1116 (Foreign Tax Credit) and even the new Form 8938 (Statement of Foreign Financial Assets). But what about Forms 926, 3520, 5471, or 8865? There are a number of rather obscure tax forms that may be specific to Americans who live abroad. If you file your taxes yourself or have the help of a hometown CPA who is not that familiar with expat returns you may not be aware of all the requirements. To avoid needless and expensive penalties, check this list for examples.
- Avoid investing in foreign mutual funds or PFICs– unless in doing so you save on your overall tax burden. Many Americans are still unaware of the IRS's particularly harsh tax treatment of foreign-incorporated investments such as overseas mutual funds and pension plans. Unless the fund is structured as a partnership, the IRS will generally classify it as a Passive Foreign Investment Company (PFIC). This involves pretty much any overseas mutual fund, pension plan, money market fund, or insurance-wrapped investment scheme.
If you‘re not sure if something is a PFIC, check with a US tax advisor before investing. Because the taxes due on PFIC earnings is in most cases much higher than what would otherwise be due on a US based mutual fund, it’s often best for Americans to avoid PFICs and instead hold their investments in a US custodian that’s friendly to expats.
There are some notable exceptions, of course. One might be if you invest in a PFIC that shields your income from enough local tax to offset any additional tax you might face in the US. For example, due to their local tax deduction, investing in PFICs such as Thailand’s Retirement Mutual Funds (RMFs) or Long Term Equity Funds (LTFs) can make sense for American expats who pay Thai income tax. Another exception might be if a local money market fund provides a currency hedge. However, unless there’s a specific reason purchase a PFIC, the tax consequences usually make these poor investment choices for expat Americans.
- If you do invest in PFICs, choose the mark-to-market option when filing Form 8621. The earnings from PFIC investments are reportable to the US on Form 8621. Using the form, those Americans who have invested in a PFIC such as a Thai RMF or LTF or another foreign fund have a choice of how to calculate the US tax due on the earnings. Unless the PFIC was originally structured so that its income and distributions allow for treatment as a Qualifying Electing Fund (QEF), in most cases the US expat taxpayer will only have two choices of the tax treatment of the PFIC, either 1) Excess distribution or 2) Mark-to-market.
The excess distribution method might at first seem the better choice, because in this case Form 8621 only needs to be filed when a distribution (such as a dividend) or a sale of shares takes place. This is misleading, however. The tax calculation on the sale or distribution incomes uses a compound income tax at the highest possible individual ordinary rates during the holding period (not the taxpayers’ actual marginal rate) plus a non-deductible interest charge compounded over the period of deferral. This makes choosing the (usually default) excess distribution method prohibitively expensive.
Instead, mark-to-market treatment will almost always result in a lower tax bill over the investment period. Using mark-to-market, a U.S. investor may elect to include each year as taxable ordinary income at his US marginal rate, an amount equal to the excess of the fair market value of the PFIC stock over the adjusted basis of the PFIC stock. (Losses can be deducted as ordinary losses.) Although this does mean filing Form 8621 each year for every PFIC, generally the mark-to-market method will be much easier to manage, and less expensive tax-wise. This is a technical area, however, so anyone holding a PFIC is urged to consult with a US tax advisor experienced in expat issues.
- Where permitted, consider whether contributing to US tax-advantaged accounts could save you long-term tax. There are many forms of US tax-advantaged accounts. If you qualify to invest in one or more of them, they can result in sizeable tax savings over the long run. Some types such as traditional IRAs, 401(k)s, or SEP IRAs can result in a deferral of taxable income and potentially a lowering of marginal tax rates in the current year. Others such as Roth IRAs, Roth 401(k)s and 529 Plans offer no tax deferral, but investment earnings are never taxable at federal or state levels - making them a bit like perfectly legal offshore accounts. It can pay to carefully research to see whether you qualify for these types of accounts and whether investing in them will save you in overall tax over the long run. There are many potential trip-ups, however – for example, consider whether you still have to pay tax on investment earnings in your country of residence – if so, these accounts may not save you overall tax unless you move somewhere else.
- Only contribute to traditional IRAs or Roth IRAs if you qualify.You can only contribute to traditional IRAs or Roth IRAs if you have unexcluded earned (salary) income. This is the case even if you do not take a tax deduction for the contribution. Expats who use the foreign earned income exclusion and earn less than the exclusion amount (?$97,500 in 2013) are not permitted to make an IRA contribution and, if audited, face a 6% penalty per year on the amount that is not permitted until it’s corrected or removed from the account.
To avoid a penalty situation, if you earn less than the foreign earned income exclusion, consider changing your method of calculating tax due to use the foreign tax credit instead of taking the exclusion – that way you will have unexcluded earned income and may then qualify to make a contribution. If switching to the using foreign tax credit isn’t tax efficient for your situation, there’s no reason you couldn’t simply invest the same amount you would have contributed in a taxable account instead. If you’re careful, you can still manage the taxable account to be tax efficient and to defer capital gains. For more information, see American Expats and IRAs: A How-To Guide.
- Avoid using already (foreign) taxed income to contribute to before (US) tax plans. This is a common error that expats make and can result in tax inefficiency and a higher US tax bill over the long run. It involves expats who have unexcluded earned income that is taxed locally and who make US deductible contributions to plans such as IRAs or SEP IRAs. While they may lower their US tax bill by a certain amount in the current year, often the current year savings is not enough to come out ahead over the long-run.
For example, consider an American expat in Thailand earning above the foreign earned income exclusion who contributes the equivalent of $30,000 to a SEP IRA. Although the entire amount may be deductible on their US income tax, the net savings in US tax may not be that great, as a large portion of the US tax on this amount would have already been offset by Thai foreign tax credits.
Another way to look at it: If a US expat’s overall tax burden (US+Thai) were reduced by $3,000 on the $30,000 SEP IRA contribution, on the plus side he would have benefited by an overall tax savings of 10% of the amount contributed. However, he would also have made the entire $30,000 contribution pretax, meaning that one day all earnings (dividends, interest, and capital gains) would be taxed at a future US rate that is almost certain to be much higher than 10%. In this case, 10% up front savings would not be worth it, and the expat would have been better off foregoing the deduction, putting the savings in a regular brokerage account, and managing it to maximize tax deferral on capital gains while enjoying overall lower tax rates and tax payable over the long run.
- Be sure to file each year, even if you do not think you owe US income tax. If you are a US citizen, permanent resident (green card holder) or hold a US passport as a secondary nationality, your worldwide income is subject to U.S. income tax regardless of where you live. Unless your income is below the filing limit (for example, $9,750 for single filers in 2012), you are required to file US income taxes every year – and this is the case even if your earnings are very low and you do not owe any US income tax.
It’s important to do so. For example, if you meet certain requirements and you file your own return outside of an audit, you may be able to exclude foreign earned income (salary income) from your US taxes – for tax year 2013, this will be $97,600. But note that the right to take the foreign earned income exclusion and other deductions such as for housing costs is voluntary and is only allowed if you file your return. If you’re audited for not filing, the IRS may disallow the exclusion and in that case you may owe tax and penalties where you would otherwise have not.
As shown in the tips above, American expats who spend some time figuring out ways they can save on US tax –especially over the long-run –will receive benefits that compound over time. If done well, long-term tax planning can really pay off for Americans abroad.
This article is an updated version of one that appeared on www.crevelingandcreveling.com on 28 Oct 2013.