Smart Year-End Tax Planning Moves for U.S. Expats Living Abroad
American expats face unique financial challenges, especially when it comes to tax planning. If you don’t stay on top of your finances, you may end up paying a premium when it comes time to file your taxes. That’s why it’s important to take steps now to end the year on a positive note. The following tips can help you prepare.
Tip #1 – Determine whether you should pay (pre-pay) your country of residence’s tax liability before year end.
In order to claim a credit for foreign (non-U.S.) taxes paid when filing your U.S. taxes, it’s often necessary for those taxes to have actually been paid during the tax year for which credit is sought. For example, if in 2023 you have $10,000 in capital gains that will be taxed by your country of residence and the U.S., you’ll only be able to claim a Foreign Tax Credit on your U.S. tax return if you already paid (or accrued) the tax to your country of residence during 2023.
Tip #2 – Confirm your eligibility for the Foreign Earned Income Exclusion (FEIE).
In 2023, the FEIE allows individuals to exclude up to $120,000 of foreign earned income for each qualifying taxpayer. The exclusion is only for foreign earned income — not passive income, such as rental or investment income. To qualify, the taxpayer must meet two criteria:
- Have a foreign tax home
- Meet one of two additional criteria:
- The bona fide residence test – To meet the bona fide residence test, you must be a resident of a foreign country for an uninterrupted period that includes an entire tax year (January 1 through December 31 for calendar-year taxpayers). You may briefly visit the United States or other countries during the period of establishing bona fide residence as long as you clearly intend to return to your foreign residence.
Once you have established residency in a foreign country for an uninterrupted period that includes an entire tax year, the date of your bona fide residency begins with the first date of your residency and ends with the date you abandon your foreign residence.
- The physical presence test – The physical presence test requires that a taxpayer reside in a foreign country for a 12-month period, which can be any period of 12 consecutive months that includes 330 full days of presence in a foreign country. Taxpayers who qualify under the physical presence test for a partial year should carefully choose the 12-month period that allows them the maximum exclusion for the year.
There’s a special concession and extension available from the IRS if you haven’t met the requirements of either the bona fide residence test or the physical presence test (whichever one you’re expecting to qualify for) by the time your return is due. You may apply for an extension of time to file your return until you meet the requirements for one of the two tests by filing Form 2350.
Remember if you used the FEIE in one year and opted not to use it the following year, you may be deemed to have revoked your election to use the exclusion, meaning you’ll be prohibited from using it again for another five years.
Tip #3 – Consider a Roth conversion.
If you’re an American living overseas and your 2023 income is less than the FEIE limit of $120,000, it may make sense to convert a portion of your pre-tax retirement funds, such as traditional IRA assets, to after-tax Roth assets. To do so, you must pay U.S. taxes on the converted amount in the current year, which is why it can make sense to complete a Roth conversion during a year in which your taxes are lower than normal, perhaps due to some of the following circumstances:
- You’re moving to a tax jurisdiction that recognizes Roth accounts or will not tax them, as noted above.
- You have retired but haven’t started taking RMDs or receiving Social Security and other pensions yet. RMDs and Social Security force many retirees into a higher tax bracket.
- You expect tax rates to rise in the future. Even if you aren’t sure what the future holds, a partial Roth conversion can provide an efficient way to protect yourself from rising tax rates.
- You’re a net U.S. taxpayer and have earned income below the foreign earned income exclusion (FEIE) and U.S. standard deduction limits.
- You expect to return to and retire in the United States, and you’re considering using a Roth conversion to lower your tax bill in retirement.
- You can make the conversion with little or no tax payable in the country in which you reside.
An effective Roth conversion strategy must factor in your current country’s tax treatment of Roth accounts. In countries that don’t recognize the tax-exempt status of a Roth withdrawal, your contributions and income earned that has been properly declared, and on which tax has already been paid, may be tax-exempt (similar to there being no tax on a withdrawal from a taxable account), but any gains generated by the need to sell securities to withdraw cash may be taxed as capital gains or ordinary income depending on the specifics of your country’s tax system. A Roth account may make sense if you live in:
- Low- or no-tax countries (like much of the Caribbean, Eastern Europe, many countries in the Middle East — such as Saudi Arabia — and even Portugal, under its non-habitual resident scheme).
- Countries that don’t tax foreign-derived income (i.e., territorial taxation nations like Singapore, Hong Kong, Malaysia, Thailand and parts of Latin America).
- A country where there’s beneficial treatment of Roth IRAs in the tax treaties between the United States and the country of residence, such as France and the United Kingdom.
A Roth conversion likely doesn’t make sense if:
- You expect your current tax rate to be lower in retirement (this may be because you’re still working and earning a relatively high income that will drop in retirement).
- You plan to spend your retirement in a high-tax country that doesn’t recognize Roth accounts, such as Australia, Germany, Italy or Japan.
- You retire in a country with unique tax policies, such as the Netherlands, where you’ll need to plan to avoid unnecessary taxation.
The process of converting a pre-tax retirement account to a Roth can be complex, so be sure to consult with your wealth manager and tax advisor before making a move.
Tip #4 – Understand what tax forms you’ll need to complete.
It can be overwhelming to navigate the various tax forms required of U.S. expats. Based on your specific financial situation, you may be responsible for submitting any combination of the following:
- U.S. Individual Income Tax Return – Form 1040
- Itemized Deductions – Schedule A
- Interest and Ordinary Dividends – Schedule B
- Business Income – Schedule C
- Capital Gains Income – Schedule D/Form 8949
- Foreign Earned Income – Form 2555
- Foreign Tax Credit – Form 1116
- Additional Child Tax Credit – Form 8812 (tax refund for overseas families)
- Treaty-Based Return Position Disclosure – Form 8833
- Foreign Bank and Financial Accounts (FBAR) – FinCEN Form 114
- Application for Automatic Extension of Time to File U.S. Individual Income Tax – Form 4868 (if necessary)
- Foreign Branch (FB) or Foreign Disregarded Entity (FDE) – Form 8858 (do you have a foreign rental?)
- Passive Foreign Investment Companies (PFICs) – Form 8621
- Controlled Foreign Corporation – Form 5471
- Foreign Partnerships – Form 8865
Importantly, many U.S. expats meet the requirements for filing taxes in their country of residence even when it’s not common for most residents of the country. You should consult with a local tax expert to ensure you meet the reporting requirements of your country of residence.
Feeling overwhelmed? Creative Planning International is here for you. We work with U.S. expats and cross-border families to help maximize their wealth and avoid costly mistakes, especially when it comes to tax planning. We understand the complex interaction of multi-jurisdiction tax and regulatory regimes and take into account currency, diversification and other portfolio considerations as we help you plan and invest for the future.
If you’re an American living abroad who could use help managing your wealth, request a meeting with a member of our team.