Taxes probably aren't your favorite topic, but the more you understand about them, the more money you can save by legally cutting your tax bill. Laura answers seven tax-related questions about working remotely, living abroad as an expat, and doing freelance work.
Unless you’re a tax accountant or lawyer, income taxes probably aren’t your favorite topic. To say taxes are confusing and time-consuming is a laughable understatement. No matter if you’re an employee, self-employed, or retired, taxes take a massive bite out of your paycheck, business profits, and investment earnings.
While taxes can be a downer, the more you understand about them, the more you can save by legally cutting your tax bill each year. In this post, I’ll answer seven tax-related questions that I recently received about working remotely, living abroad, and doing freelance work.
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7 Questions & Answers About Taxes
Tax Question #1
Rachel L. says, “I’m an American who’s been living in Canada for many years. How can Americans who live and work abroad avoid having to pay taxes in two different countries?”
Rachel is one of the estimated 9 million Americans who live outside of the U.S. Whether you leave to work for an employer, do freelance work while globetrotting, or retire in another country, you can’t escape Uncle Sam’s tax system.
Unlike most countries, the U.S. taxes its citizens no matter where in the world you live. So, even if you never expect to move back, you still must file an annual tax return that includes all your worldwide income, as if you never left.
Unlike most countries, the U.S. taxes its citizens no matter where in the world you live.
Trying to hide your foreign income became more difficult after 2010, when the Foreign Account Tax Compliance Act (FATCA) was enacted. It requires all foreign financial institutions to report U.S. customers to the IRS. This leaves expats in danger of stiff back taxes and penalties if you don’t comply with U.S. tax laws.
However, the good news for U.S. expats is that you probably qualify for some nice tax breaks. To qualify, you must have a tax home in a foreign country and receive foreign earned income.
The biggest benefit when you live and work outside of the U.S. is the foreign earned income exclusion. It allows you to reduce your taxable income by up to $101,300 for 2016 per qualifying person. There are also foreign tax credits that may reduce or eliminate what you owe. You claim these benefits by submitting Form 2555 along with Form 1040.
Also note that you can still get a tax refund as an expat, but only if you continue filing annual tax returns. If you have foreign income and don’t file a U.S. tax return, you can’t claim any exclusions or credits, and are breaking the law.
As I mentioned, getting caught not paying U.S. taxes can result in high penalties. If your tax delinquency is at least $50,000, the State Department can even cancel your passport. So, don’t think you can fly under the IRS radar just because you’re no longer living in the U.S.
For much more information, check out Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. And be sure to consult with an experienced tax accountant if you have any questions.
Tax Question #2
Elisabeth B. says, “I’m an American in my early 20s, living and working full-time in Europe for the next few years. I have about $20,000 in my U.S. credit union in a mix of mutual funds, CDs, and savings accounts. I’m financially stable and wondering if my American money could be doing more for me. Can I open an IRA in the U.S. even though I’m earning income abroad?”
Thanks for your question, Elisabeth, and congratulations for having a nice chunk of savings at such a young age. One of your top financial priorities should be to maintain a healthy cash reserve, known as an emergency fund.
Having a financial safety net is critical because it keeps you from going into debt if you have a large unexpected expense or hit a rough patch, like losing your job or business income.
Having a financial safety net is critical because it keeps you from going into debt if you have a large unexpected expense or hit a rough patch, like losing your job or business income. How much savings you need is different for everyone, but I recommend keeping at least 3 to 6 months’ worth of living expenses on hand.
Another good rule of thumb is to maintain at least 10% of your annual gross income in an emergency fund. For instance, if you earn $50,000, make a goal to accumulate a minimum of $5,000 in cash reserves.
But don’t be tempted to invest your emergency fund. Exposing it to any amount of risk means it could lose value the moment you need it. To have a healthy financial life you need different buckets of money, each with their own purposes.
The purpose of an emergency fund isn’t to earn money or grow, but to stay safe for future potential financial disasters. So, in general it should always sit tight in a high-yield, FDIC-insured savings account.
Once you’ve got some cash set aside or are saving to an emergency fund on a regular basis, it’s time to start another bucket of money that you want to grow for the future, such as a retirement account.
But is Elisabeth eligible for an IRA while living abroad? To qualify for any type of IRA, you must have some amount of taxable, earned income. As I previously mentioned, expats can typically exclude up to $101,300 of income from taxes, for 2016.
So, unless you choose not to take the foreign income exclusion or you earn over $101,300, you won’t qualify to make IRA contributions. However, you can still invest using U.S. dollar-based, taxable, brokerage accounts.