As an American working overseas, do you know that you may not have to pay US taxes on your investment income? It came to me as kind of a surprise since we usually focus on how our earned income may be eligible for exclusion. I didn’t really think the IRS would want to hand out an additional tax break.
Nevertheless, it’s pretty straightforward how current tax code allows US taxpayers working outside of the US to escape taxation on some investment income. It’s not even something special you have to do. Depending on your income level, you may simply find that you pay no taxes on your dividends, interest, or capital gains.
This presents some good tax planning opportunities. Let me show you how Americans working overseas get tax-free investment income.
How Americans working overseas get tax-free investment income
Here’s an example.
- You are a married couple without kids, working and living together overseas.
- You both qualified for Foreign Earned Income Exclusion (FEIE) under the Bona Fide Residence test or Physical Presence test.
- Both spouses make USD 100,000 in salary a year.
- Your also make $20,000 in Long-term Capital Gains and Qualified Dividends last year.
Since both of your incomes are lower than the current exclusion limit of $102,000, you don’t pay US taxes on your salary. After you enter all the numbers on Form 1040, you’ll find that:
- You have an Adjusted Gross Income of 20,000 (all from investments).
- You can take a Standard Deduction of $24,000 (in 2018; married filing jointly).
- Your taxable income is…. ZERO!
As you can see, as long as your other income is below deduction, you don’t pay US taxes.
The same couple living in the US, making the same salary, will have to pay $20,000 * 15% = $3,000 in taxes on the same investment income.
This is just one year. If you work overseas for an extended period of time, this savings in taxes can add up, if you diligently reinvest into the market instead of spending it.
How about if you have children?
Let’s assume all the same facts as in the previous scenario, but you have two beautiful toddlers. You still both work full-time, so you hire a nanny that costs you at least $6,000 a year.
Starting in 2018, not only do you get Dependent Care Credit, you may also be eligible for full Child Tax Credit at this income level.
This is when it gets tricky. Since you may only take Dependent Care Credit and Child Tax Credit against Earned Income, excluding your entire $200k salary could mean you may not get any child related tax benefit.
Nevertheless, if you make more than the FEIE limit, it’s still possible to still take advantage of the credits. This means that potentially these child related tax credits may eliminate all taxes from Earned Income, leaving the $24,000 standard deduction to reduce taxes on your investment income.
Compensate for limited access to Tax-advantaged Accounts
In a sense, this favorable treatment more than compensates for the fact that Americans taking FEIE cannot shelter investments in tax advantaged IRAs.
First of all, your earned income is tax free in the US (up to FEIE limit), so you are investing tax-free income. Then the return from this tax-free savings is also tax-free (to an extent), as long as you continue to qualify for FEIE.
Assuming you are a buy and hold investor in index funds, your annual dividend yield plus returned capital gains can be quite small. Let’s say it’s about 10% of your annual portfolio balance.
It means that in order to generate $24,000 in investment income, you need to have a portfolio size of $240,000.
Many US expats only started saving in taxable account because they worked overseas and no longer have access to 401(k)s. So to get to a portfolio size of $240,000 from zero, it would take a few years. In all those years, the investment income could be tax free, depending on your income and the tax laws you are subject to.
Of course, you may say that this is still not as good as the forever tax-free treatment on the gains of Roth IRA contributions. But remember, you have to pay income-taxes up front on your contribution, and the maximum contribution is only $5,500 (or more if you have access to a Roth 401(k).)
Furthermore, in certain earning scenarios, it is still possible for you to contribute to a Roth IRA. For example, if one of you earns above FEIE limit, and together your AGI + FEIE is still less than the income limit. All of the above favorable tax treatment still applies to you, plus you get to contribute to a Roth IRA.
Coordinate with your host country’s tax law
All things sound great up to this point, but we have yet to talk about one thing – paying taxes in your resident country. The US IRS allows you to take FEIE for a reason. It’s likely that you are paying local taxes, so FEIE allows you to not get double-taxed.
Nevertheless, not every country in the world taxes expats that live and work there. Some may have much lower tax rates. The others may give higher exemptions for foreigners. Taking FEIE in these circumstances can greatly lower your tax liability in your most productive years.
On the other hand, there are definitely countries in the world that tax their residents at a higher rate than in the US. In this case, you may choose to pay taxes on the full income in the US, and take a Foreign Tax Credit against the tax you’ve paid abroad.
As you might have guessed, the tax-free treatment on the investment income does not exist in this scenario.
Using the same facts in Scenario 1, you will have to pay taxes like the following:
15% on $20,000 in investment income = $3,000
Ordinary tax rate (24% tax bracket) on $176,000 in salary = $30,819
Total Tax = $33,819
This means that if you are paying more than $33,819 in taxes to your host country, it might be better to claim the credit.
Lastly, you may also want to find out whether your host country taxes you on your foreign investment earning (from their perspective.) In some cases, you may have to find out the specifics from the tax treaty. I recommend working with a professional tax accountant to do the planning beforehand.
(As a side note, what I provide here is a much simplified scenario. It’s likely your situation is much more complicated and involves other taxable income, deduction and credits, both in the US and your host country. Please consult a tax professional before applying any of these scenarios to your own.)
Rental Income and Losses
Let’s broaden our discussion here to include rental income. What happens if you are also renting out your US home while you live abroad?
- In addition to the facts as in Scenario 1, you also have rental income.
- Due to depreciation, you actually have a net loss of $20,000 that you report on your tax return.
- Active participants of real estate activities get to deduct up to $25,000 of losses in current year against other income.
- If you were in the US, your modified adjusted gross income (MAGI) would be above the limit ($150,000) for current year deduction. The $20,000 loss would be suspended until you are able to use it or until you sell the property.
- However, because FEIE is not an add back item of MAGI for this purpose, you will be able to take the full $20,000 deduction against the $20,000 investment income.
Note that while your taxable income is still zero, this may not the best outcome. The $20,000 investment income would have been tax-free anyway. Instead, the loss you could have used to deduct profit in future years is permanently gone.
Furthermore, it’s likely part of the $20,000 loss came from depreciation that will be recaptured at 25% tax rate when you sell the property in the future.
This scenario just amplifies the importance to do proper tax planning with a professional when you are overseas. The current year tax may be zero in a lot of scenarios, but they may result in different long-term tax consequences.
So what are some of the potential opportunities for planning when you take FEIE and you might not have to pay taxes on your investment income? Here are some suggestions:
- If you are moving overseas or returning to the US, time the sale of your taxable investment so that you save on taxes on some of the capital gains.
- If you have large built-in gains in some stocks, use the time you take FEIE to gradually take the gain tax-free and diversify.
- When you rebalance your portfolio, keep the gain close to the level where you don’t have to pay taxes.
What other strategies do you have in mind? Leave your thoughts below!