Saving for retirement while living overseas
I received a question from a reader about how to save for retirement in his Roth IRA, while living outside the United States. Specifically, he wanted to know whether he could just pay taxes on the amount he wanted to contribute to an IRA and exclude the rest.
If you earned less than $87,600 in 2008 and take the foreign earned income exclusion (FEIE), you have to take it on all your income. You can’t separate out a portion in order to contribute to an IRA.
However, if you earn more than $87,600, anything over this amount but below $5000 can be contributed to an IRA. So for example, say you earned $91,000 in 2008. The difference – $3400 – can be contributed to an IRA because you will also be paying US taxes on the $3400.
If you don’t earn over the FEIE amount of $87,600, one other possible way to contribute to an IRA is to take the foreign tax credit instead of the FEIE. This can be done by filing IRS Form 1116. Depending on the tax rates of your current country, if they are a similar level to the US, you may still end up owing none or very little US taxes on your income after subtracting the foreign taxes you’ve already paid. But if your foreign tax rates are low, you may owe a lot of US taxes not covered by the credit.
By taking the foreign tax credit though, you can contribute the full $5000 (assuming you earn > $5000) to an IRA since all your earnings are potentially subject to US taxes. This is still true even if the tax credit for the foregin taxes completely wipes out your US tax liability.
It’s definitely worth doing both Form 1116 (foreign tax credit) and Form 2555 (FEIE) to see which works out better for you.
Here are two articles that might help:
http://www.irs.gov/pub/irs-pdf/p54.pdf
http://www.aca.ch/joomla/index.php?option=com_content&task=view&id=156&Itemid=46
Link to form 1116 and the instructions:
http://www.irs.gov/pub/irs-pdf/f1116.pdf
http://www.irs.gov/pub/irs-pdf/i1116.pdf
Emotional side of buying (or not buying) a home
Now that we’re staying in DC and had already saved up a substantial amount of money for the move, we are seriously considering purchasing a home. I’ve been wanting to buy for several years now, but since we were always planning on moving to London, it never made sense. Of course, I’m very glad we didn’t buy a couple of years ago since it would have been at the height of the market.
So being a first-time buyer, I sought out friends who had recently bought a home, did some research online and started moving forward. First, I submitted an online application on lendingtree.com. That seemed to bring in a lot of offers, but I was a little concerned that I hadn’t heard of any of the companies. Next, I submitted a pre-approval application to Bank of America, where we have our large checking account. We were approved for their No Fee Mortgage Plus Loan, which seems pretty good. Closing costs are low, but you pay for it with the points. Even still, the loan seemed to work well for us.
A friend had recommended her realtor. After some email exchanges on what type and price of home we were looking for, I spent Sunday looking at 10 places. Five at open houses and five with our realtor. Out of the 10, we saw one viable option. By viable I mean somewhere that was in our price range, close to public transportation, didn’t need too much work and was in a safe neighborhood. Unfortunately the one viable option was at the very top of our price range.
However, our realtor thought a low offer within our budget might do the trick. So for two blissful days, I really thought we might actually end up with a three level, two bedroom townhouse that was in excellent shape. Everything I could have wanted! While the loan numbers worked out to pretty much what I had estimated, the ridiculous condo fees completed busted out mortgage payment. Well that and the fact that our dream home’s zip code was labeled as a “declining market” by Bank of America meaning that we could could no longer use the No Fee Mortgage Plus Loan. I’d like to know just how many markets in the US right now would not be determined “declining”!
While the more expensive mortgage was annoying, it was really the condo fees that sunk the deal. Condo or home association fees could be an entire post by themselves! While the property that we were considering was a townhome, the community is organized as condominiums. The fee was almost $400 dollars a month. A huge amount considering that it wouldn’t go towards building equity and couldn’t be written off as a tax deduction. The fee covered some utilities but also went to landscaping, snow removal, and exterior maintenance of the townhomes. While I appreciate that it’s great that someone else will fix the roof if it starts to leak, I’d much rather be the one deciding the timing and extent of such repairs.
In the end, we couldn’t justify the huge chunk of our monthly income that would go towards all our housing costs and ended up not making an offer.
I, however, was truly upset. I had imagined us living there already with plenty of space for our growing family, no other dogs in the building to upset our dog, room for guests and entertaining, a chance to buy some real furniture, and no more ridiculous rent increases.
While I had not “fallen in love” with the townhouse, I was seduced by what it represented. Fortunately, my sensible husband and I spent a couple of evenings looking hard at the costs and our monthly budget. If not, I might have been tempted to go ahead and hope for the best.
US Income Taxes for Expats – Foreign Housing Exclusion or Deduction
Continuing my mini-series on filing your US income taxes while living and working overseas, this post will focus on how and when to use either the foreign housing exclusion or deduction.
Check out my other posts on this topic:
- Basics of US Income Taxes for Americans Living Overseas
- How to Use the US Foreign Earned Income Exclusion (FEIE)
Foreign housing exclusion vs. foreign housing deduction
There’s a very easy way to know whether you should use the exclusion or the deduction.
If you work for an employer and you pay for housing out of your salary or your employer gives you a housing allowance, then you can only use the foreign housing exclusion.
If you’re self-employed, then you use the foreign housing deduction.
If you do a little bit of both – traditional employer salary and self-employed income, then you can use both the exclusion and the deduction, but you calculate the housing exclusion first more below).
Calculating the foreign housing exclusion
First, you calculate the base housing amount which is equal to 16% of the foreign earned income exclusion, so in 2008, 16% of $87,600 is $14,016. If you are living in a foreign country for entire calendar year, you use $14,016 as your base housing amount. If you’re only there for part of the year, you multiply the $38.30/day rate by the number of full (24 hour) days you lived in the foreign country.
Next, you calculate your housing limit which is typically 30% of the foreign earned income exclusion. For 2008, the full year amount would be $26,280 or $71.80 per day if you’re only living abroad for part of a year. If you live in a high-cost locale, however, the limits can be much higher. For example the London housing limit is $82,900! A list of the 2008 housing limits can be found in the IRS form 2555 instructions.
Once you have the base housing amount and housing limit amount, you can figure your exclusion. Say your housing expenses were $2000/month or $24,000 for the year. The $24,000 is under the housing limit for a standard city, so you can use your full housing costs for the calculation. Subtract your housing costs ($24,000) from the base amount for 2008 full year ($14,016) and you have $9,984 of excludable housing expenses.
A huge drawback is that the foreign housing exclusion can only be used for rented housing. You cannot exclude the cost of paying off your mortgage or any interest payments that are deductible.
Interaction with the Foreign Earned Income Exclusion
Here is where this gets a little complicated. Once you’ve figured out your excludable housing amount, $9,984 in the above example, you subtract it from your foreign earned income. Continuing our example, if you earned $95,000 in foreign earned income - $9,984 would your foreign housing exclusion and $85,016 would be your foreign earned income exclusion.
The maximum amounts of income and housing that you could exclude at the 2008 rate would be ($87,600+($26,280-$14,016) ) $99,864 at a standard rate locale. For a high-cost city the excludable amounts could be much higher. For example, in London, you could exclude up to $156,484 ($87,600 + ($82,900-$14,016) for 2008. Bear in mind though, you would actually have to be spending the $82,900 on rent – that’s $6908 per month!
If your income is more than the maximum for your city, then you will owe US taxes on the amount over your exclusions.
Calculating the Foreign Housing Deduction
Remember, you can only use the foreign housing deduction if you have self-employment income. You use the same limits as described above for the foreign income exclusion. Your deduction amount cannot be more than your excluded foreign income.
If you are self-employed and have a regular job, you would calculate the exclusion amount first then deduct the remainder of your allowable expenses. All of this would be subject to the same limits as above. One last thing to note is that your housing deduction cannot be more than the housing exclusion.
Forms
To claim the foreign income and housing exclusions, you will need to file Form 2555 (instructions can be found here). File this form with your other tax forms.
Resources
IRS Publication 54 – Tax Guide for U.S. Citizens and Resident Aliens Abroad
How to Use the US Foreign Earned Income Exlusion (FEIE)
As discussed in my previous post, “Basics of US Income Taxes for Americans Living Overseas“, there are two paths to reducing or eliminating US taxes on income that you’ve earned in a foreign country. Bear in mind that in all likelihood you’ve already paid income taxes to the country you’re living in. Therefore, you’d probably like to avoid paying US taxes on your income as well! In this post, I’m going to focus on the specifics on the foreign earned income exclusion (FEIE) including eligibility, what kind of income it applies to and how to use the exclusion. In my next couple of posts, I’ll be covering the foreign housing exclusion and deduction and then the second method of reducing your US taxes, the foreign tax credit.
The Foreign Earned Income Exclusion is currently suffering from the same problem as the Alternative Minimum Tax (AMT). Originally intended to capture only wealthy individuals when it was introduced in 1982 at a cap of $75,000, it was not indexed to inflation at that point. The FEIE was only indexed to inflation beginning in 2005, and therefore subjects greater numbers of individuals with average incomes to double taxation. If the FEIE had been indexed to inflation from the beginning, it would be now stand at $166,000 in 2008. A very interesting (but long) article about the history and current issues of taxing Americans living abroad can be found here.
What qualifies as earned income?
- Salaries and wages
- Commissions
- Bonuses
- Professional fees
- Tips
The following items may qualify as earned income, but will depend on your specific circumstances:
- Business profits
- Royalties
- Rents
- Scholarships and fellowships
- Lodging, meals or use of a car provided by your employer
Unearned income (not excludable under the foreign earned income exclusion):
- Dividends
- Interest
- Capital gains
- Gambling winnings
- Alimony
- Social security benefits
- Pensions
- Annuities
You might have noticed above that pensions and annuities are not covered by the FEIE. This means that if you are retired and living abroad, you will owe US taxes on the full amounts of monies paid out to your from your pensions and annuities! However, I believe distributions from traditional IRAs are treated as ordinary earned income and therefore can be excluded by the FEIE as long as you are older than 59.5 when you take the distribution. For Roth IRAs, all distributions should be tax-free, again as long as you are older than 59.5.
If you meet either the bona fide residence test or physical presence test and your tax home is in a foreign country, you can use the foreign earned income exclusion. The bona fide residence test is met by setting up residence in a foreign country and having lived there for an entire tax year with the expectation that your residence will be of an indefinite time frame (e.g. not a temporary assignment). The physical presence test is met by being in a foreign country for 330 days over a consecutive 12 months. Either of these test qualify you to take the FEIE. In 2008, the excludable amount is $87,600. If you are married and your spouse is also subject to US taxes, you can both take the exclusion and exclude up to $175,200.
Once you make the choice to use the foreign earned income exclusion, it remains in effect until you revoke it. You can revoke your choice by attaching a statement to your tax returns. Please note that if you decide to use the FEIE again within 5 years, you have to apply to the IRS for approval.
Possible Drawbacks
If you don’t earn more than the FEIE cap ($87,600 in 2008), it’s good news in that you won’t owe US taxes in addition to the foreign taxes you’ve probably already paid on the income. However, if you are planning to continue contributions to an US traditional IRA, Roth IRA or 529 college savings plan, you will not be able to do so if all our foreign income is excludable. This is due to the fact that all of these accounts are tax-advantaged, and if you’re excluding your income from US taxes, you cannot receive the tax benefits. I’ll talk about one way to continue funding these accounts in a subsequent post on the foreign tax credit.
In addition, use of the FEIE may also affect your ability to take normal credits and deductions such as the the Child Tax Credit.
Interaction with the Foreign Housing Exclusion
In my next post, I’ll be explaining how the foreign housing exclusion and deduction work. If you use the foreign housing exclusion, it reduces the amount of the income that you can exclude.
Forms
To claim the foreign income and housing exclusions, you will need to file Form 2555 (instructions can be found here). If you’re only claiming the foreign income exclusion, are not self-employed and make less than $87,600, there is also a short version, Form 2555EZ (instructions can be found here). Both of these forms would be filed with your other tax forms.
Resources
IRS Publication 54 – Tax Guide for U.S. Citizens and Resident Aliens Abroad
Disclaimer
Please note that I am not a tax professional. The above post is for informational purposes only. If you have specific tax issues related to living outside your home country, you should contact a tax professional.
Basics of US Income Taxes for Americans Living Overseas
Introduction
A lot of people are surprised when I tell them that the United States is one of the only countries in the world that taxes its citizens on their worldwide income. Many other countries will tax you if you live abroad only part of the year or are ordinarily considered a resident for tax purposes. But the US, even if you haven’t lived in the States for 20 years, Uncle Sam wants to know about your income every year! Which means filing from abroad and making some decisions on how you want to treat your income.
Do you need to file?
If your total worldwide income is above the following amount for your filing status, you will have to file an income return. The below table is from IRS Publication 54 linked at the bottom of this post. For those that are self-employed, if your net earnings are above $400, then you also need to file.
Filing Status – Amount (values are for 2008)
Single – $ 8,950
Single 65 or older – $10,300
Head of household – $11,500
Head of household 65 or older – $12,850
Qualifying widow(er) – $14,400
Qualifying widow(er) 65 or older – $15,450
Married filing jointly – $17,900
Married filing jointly, Not living with spouse at end of year – $3,500
Married filing jointly, One spouse 65 or older – $18,950
Married filing jointly, Both spouses 65 or older -$20,000
Married filing separately – $ 3,500
Tax Basics for Expats
The US tax year is the same as the calendar year, so Jan 1 to Dec 31. You must file your tax return by the following April 15 whether or not you owe money or are due a refund. Exceptions to this include if you’re self-employed and you pay estimated taxes quarterly.
If you are living overseas on April 15, you are automatically granted a two month extension to June 15. You don’t have to file any special forms to receive the extension but you may owe interest on any taxes due for that two month period. So in my opinion, it’s better to go ahead and get it over with and file by April 15. However, one reason to take advantage of the extension if you need the extra two months to meet the bona fide residence test or physical presence test. If you do use the two month extension, you must attach a statement when you file your taxes explaining that you are living and working outside the US.
Five Cent Nickel offers a succinct explanation of the US tax rates in “How do Federal Income Tax Brackets Work?”.
Determining Your Tax Home
If you are a resident of another country, have established a residence and are living there for at least one full tax year, then you meet the bona fide residence test and can claim that country as your tax home. You can also use the physical presence test of living in a foreign country for 330 days out of twelve consecutive months to determine your tax home.
US Citizens Filing from Overseas
So as we’ve already discussed, even if your tax home is in another country, the IRS wants you to file income tax returns every year. This could mean you are paying taxes in both countries, also known as double taxation. Don’t panic yet though! There are two options to reduce or completely cancel out your US taxes.
The first is the foreign income exclusion. In 2008, you can exclude up to $87,600 of your foreign income. If you make less than that, you will owe no US taxes on that money. If you make more than the $87,600, you will pay taxes at the US marginal tax rate for that income level. You may also be eligible to claim the foreign housing deduction. To claim the foreign income and housing exclusions, you will need to file Form 2555 (instructions can be found here). If you’re only claiming the foreign income exclusion, there is also a short version, Form 2555EZ (instructions can be found here). Both of these forms would be filed with your other tax forms.
The second option is to claim a foreign tax credit for the taxes you’ve already paid to the country in which you currently live. If you are working in a country that has similar or higher tax rates to the US, then this may be more beneficial to you. To claim the tax credit, fill out Form 1116 and include it with your other tax forms. Instructions for Form 1116 can be found here.
I’m going to publish a post soon on how to choose between the income exclusion and tax credit options as which path you take can affect any contributions you might be making in the US to retirement or college saving tax-advantaged plans.
Other Paperwork
If you have substantial funds (more than $10,000) in a bank, brokerage or other type of financial account, then the Treasury Department wants to hear about it. This form can be found here. Note that you do not send this form in with your taxes, but send it directly to the Department of the Treasury (the address is included in the form).
What if I haven’t been filing my returns?
Lastly, what if you’re reading this and you have been living outside the US for years and haven’t filed a tax return since you left? Don’t worry, this happens all the time, but you should contact a tax professional familiar with US taxes and begin filing the missing returns right away.
Disclaimer
Please note that I am not a tax professional. The above post is for informational purposes only. If you have specific tax issues related to living outside your home country, you should contact a tax professional.
Resources
IRS Publication 54 – Tax Guide for U.S. Citizens and Resident Aliens Abroad