Whether you’re a US citizen living abroad or a digital nomad making your way across the globe, you need to pay taxes. However, navigating taxes as an expat or globe hopper can be confusing and expensive. It can affect your income taxes, and if you’re not careful, you could even face the risk of double taxation.
Thankfully, there are several strategies to ensure tax savings for expats and digital nomads.
A note on terminology
Before we discuss tax savings for expats and digital nomads, it’s important to understand exactly what we mean by the terms ‘digital nomad’ and ‘expat’.
Digital nomads include creators, business owners, freelancers, working professionals, and anyone with a side hustle. Your geography isn’t the most important feature here. Instead, the term focuses on how you make your money.
An expat, on the other hand, is all about where you are. This refers to a US citizen who is still a US tax resident living outside of the country.
Regardless of which category you’re in, the goal is to lower your effective tax rate, or the percentage of your income that goes towards paying taxes. While there are online tools available to help you calculate this, here’s the basic formula:
Total taxes paid/total income
Now, let’s investigate how you can lower your effective tax rate.
How do US taxes work when you live abroad?
The US currently uses a citizen-based tax system. As long as you’re still a US citizen, you should be paying taxes to the IRS.
There are several factors that expats need to consider when it comes to filing their taxes:
- The IRS’ minimum filing requirements. For the 2023 tax year, they are $12950 (if you’re younger than 65) or $14700 (if you’re 65 or older).
- The levels of taxes you’ll need to pay. For example, you’ll need to pay state taxes according to the requirements of the state you lived in before you moved.
- Self-employed expats may still be subject to self-employment tax (which is approximately 15%).
- As an expat, your investments are still subject to capital gains tax.
- The country in which you currently reside might also require you to pay income taxes.
With so many factors at play, consider consulting with a tax professional to ensure compliance while you access tax savings for expats and digital nomads.
Regardless of how the above-mentioned factors influence your filing, here’s how you can save money on your taxes
Foreign-Earned Income Tax Exclusion (FEIE)
As the name suggests, this allows you to exclude part of your foreign-earned income when filing your US taxes. This amount is adjusted annually for inflation, but for the 2023 tax year, it covers up to $120,000.
However, it’s important to note that this exclusion only applies to earned income. That is to say your salary, bonuses, commissions, sale of online courses or digital products, and sponsorships. Passive income like interest, dividends, and your pension are not eligible for FEIE.
Unfortunately, this exclusion does not change your tax bracket. Moreover, you can’t exclude your self-employment taxes.
Foreign Housing Exclusion
For US citizens living abroad, the IRS allows you to deduct certain housing expenses from your tax payments. Generally, you can exclude up to 14% (or roughly $16800 for the 2023 tax year). However, there are limitations.
Firstly, the amount you can exclude depends on the city in which you now live. The IRS considers some cities to be more expensive than others. As such, residing in these cities can mean a higher exclusion amount. Secondly, this exclusion mainly covers expenses like rent, occupancy taxes, and some utilities. Then, there are ‘tests’ to see whether you qualify for the exclusion.
- The physical presence test mainly affects digital nomads. The requirements are that you spend more than 330 full days in one or more foreign countries during a 12-month period. Note that the IRS tracks this very carefully, so if you are in the US at all during this time – even for a few hours – you will not qualify.
- The bona fide residence test has implications for expats. To qualify, you need to live in a foreign country for an entire calendar year, with no plans of returning for the foreseeable future.
These are not strictly self-assessment tests. To include them as evidence in your tax filings, you will need to provide the relevant facts to the IRS, where you will be given feedback. In some instances, the IRS refuses to allow taxpayers to make use of the foreign housing exclusion.
Foreign Tax Credit
This is a separate tax benefit from FEIE, meaning that you could apply for both on the same return. This credit is particularly beneficial to expats paying income tax in a foreign country. It can help you to reduce your US tax obligations, in turn, helping reduce double taxation (paying tax twice on the same income – once in the US, and once in your country of residence).
In a nutshell, the foreign tax credit allows you to take a dollar-for-dollar credit or reduction on the taxes you pay in another country, and use that on your US income tax.
Electing to be Taxed as a Different Entity
The benefits of different tax entities can vary. For both expats and digital nomads, there are tax advantages to being a self-employed business owner. A primary advantage is easier tax filing, as you’ll only need to complete one tax return.
While this is an attractive option for small businesses, if your business scales up and starts to bring in more revenue, self-employment tax can become quite expensive. After all, it is currently 15% (and includes social security and Medicare taxes).
One way for high-income expats and digital nomads to save on taxes is to elect to be taxed as an S Corp. This entity offers pass-through taxes, and protects you from legal liability. But there’s an added advantage. One of the requirements of S Corp is that the owner be paid a fair market salary. Thereafter, income is paid as distributions.
For example, if your company made $100,000 and you pay taxes as an LLC or sole proprietor, you’ll pay 15% of that in taxes. This means you’ll pay $15,000 self-employment tax.
As an S Corp, the earned income of $100,000 must be divided into your salary and profits. Only the salary part of this revenue is taxed. Say you give yourself a salary of $50,000. Paying a 15% self-employment tax on that is $7500. Since the remainder of your revenue is not subject to self-employment taxes, your overall tax is only $7500, saving you half of what you would have paid as an LLC.
Of course, these calculations are not quite as straight-forward as the above example; other factors may come into play. To make the most of a tax entity change, it’s always best to consult with a CPA.
Choosing a Worthwhile Retirement Account
Did you know that self-employed expats and digital nomads have access to the best retirement accounts in the US? It’s called a Solo 401(k). A Solo 401(k) combines the high contribution limits of a corporate 401(k) with the flexibility of a private account, so you can run a Solo 401(k) any way you would like to.
To be eligible for a Solo 401(k), you need to be a business owner or self-employed individual with no full-time employees. Having this account means that you’re technically the employer and employee, so you can choose a contribution limit on both sides.
There are five main ways that this account can help with tax savings for expats and digital nomads:
- It features the highest contribution limits of any of the main retirement accounts. For the 2023 tax year, that limit is $69,000, or $73,500 if you are 50 or older. The contribution is also pre-tax, so it reduces your taxable income by that amount.
- It allows you to invest in any asset class you would like to, including cryptocurrency, startups, and private equity. The only exception is for collectibles.
- A Solo 401(k) features tax-free compounding. This means you can buy and sell assets without paying taxes. You’ll only need to pay tax on the money you withdraw from the account on retirement. As a bonus, you can avoid this tax altogether by setting up a Roth IRA account.
- It’s possible to borrow money from a Solo 401(k) at any time and for any purpose, provided this falls under the maximum limit of either $50,000 or 50% of the account value. While you will pay market-rate interest on any funds you withdraw, it goes back into your Solo 401(k).
Despite the potential challenges, it’s still possible to ensure tax savings for expats and digital nomads. With the strategies listed above, you can make sure that you’re not paying any more tax than you need to.
For help with any of these strategies, and to see how best you can save on taxes, schedule a discovery call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
