Technology has made the digital nomad lifestyle possible. With easy internet access and cloud-based platforms, making a living is no longer confined to a physical office. Digital nomads can operate remotely while traveling around the world. They can work in places such as cafes, libraries, recreational vehicles, and even the beach if the connection is strong enough.
As the world moves towards a global economy, digital nomads need to understand the tax laws around their income. American citizens and Green Card holders who are digital nomads must pay taxes on their income, even if earned outside of the United States. If you fail to file your tax returns or owe money on your U.S. tax returns, you can be hit with steep penalties.
Do digital nomad Americans have to file a U.S. tax return?
In most cases, yes. If you are an American citizen or Green Card holder and earned over $12,400 in wages or $400 in self-employment income in 2020, you are required to file a U.S. tax return. It doesn't matter which country or countries you earned this money in; digital nomads must report their global income on their US federal tax returns.
If you are filing from overseas, the IRS gives you an automatic extension until June 15. Digital nomads who need more time can request an extension until October 15 by filing Form 4506.
Keep in mind that an extension gives you more time to file your tax return. It doesn’t give you more time to pay your taxes; in fact, you could be charged a penalty for paying late. And if you forget to extend your tax return, you could be hit with a late filing penalty.
Don’t forget to check the rules for the country you live in. You may be required to file and pay taxes to the local authorities.
Do digital nomads have to pay U.S. income taxes?
Even if you are required to file a U.S. tax return, you may not have to pay any taxes. An American Expat may qualify for an IRS credit or exclusion, which could eliminate or reduce the amount of U.S. taxes that they owe.
Foreign Tax Credit (FTC)
If you pay taxes on your income in another country, the Foreign Tax Credit can allow you to offset what you paid against what you owe. If the country you live in has a higher tax rate than the United States, this credit may eliminate your tax bill entirely. Digital nomads can claim the Foreign Tax Credit by completing Form 1116.
Foreign Earned Income Exclusion (FEIE)
Under this IRS provision, American digital nomads can exclude as much as $107,600 (2020) of their overseas earnings from being taxed in the U.S. To qualify, you must demonstrate that you are a bona fide resident of another country or have had a physical presence of at least 330 days outside of the U.S. during the tax year.
It's important to note that the FEIE does not apply to unearned income. Passive sources of income, such as rental income, stock trading, IRA distributions, and social security benefits cannot be excluded from income and are still taxable.
To claim the Foreign Earned Income Exclusion, you must file Form 2555.
A few things to know about the FEIE
- Must elect to exclude foreign income: Choosing to exclude foreign income is more than just checking off a box. The FEIE election is made when you file Form 2555 for the first time. You need to ensure that you have filed your tax return on time, including extensions. If you didn’t file your tax return timely, the IRS could deny the exclusion.
- Ineligible for other tax credits: When you elect to exclude foreign income, you can no longer take advantage of the Additional Child Tax Credit. You are also ineligible for the Earned Income Credit.
- Revoke your election in writing: Once you elect the FEIE, it stays in effect until you revoke the election. You need to attach a written statement to your tax return to remove the election. But if you change your mind within five years, you need to get the IRS’s approval to use it again. According to the IRS, it is not necessary to “affirmatively revoke your choice” if you have no foreign earned income.
Foreign Tax Credit vs. Foreign Earned Income Exclusion: Which is Better for Expats?
You can't claim the Foreign Tax Credit and Foreign Earned Income Exclusion on the same income. But with a little bit of planning, you may find one option that gives you a greater tax benefit than the other. In other situations, you may be able to use both to reduce your U.S. tax liability.
How the Exclusion Works: As an example, assume that you live in a country with a 10% tax rate. If you make $100,000 in wages, you would have paid $10,000 in foreign taxes. Butiif the U.S. tax rate is 20%, your tax liability is $20,000 ($100,000 x 20%). Since you’ve already paid in $10,000 in foreign taxes, you would owe an additional $10,000 if you used the Foreign Tax Credit. However, the Foreign Earned Income Exclusion (FEIE) allows you to exclude up to $107,600 of earned income when you file your U.S tax return. By using the FEIE, you can exclude the $100,000 of earned income from your return, thus eliminating your U.S. tax liability altogether.
How the Credit Works: Under the same scenario above, assume that you earned $100,000 in wages in a foreign country with a 10% tax rate. You should have paid $10,000 toward taxes into the country you reside in. When you file your U.S. individual tax return, you can offset the federal tax you owe againstwith the $10,000 that you’ve already paid. So if the U.S. tax rate is 10%, you would owe $10,000 in taxes. Since you’ve already paid in $10,000 to the country your live in, you won’t owe any additional tax on your earned wages.
If the tax rate you pay in the foreign country is higher than the U.S. tax rate., choosing the Foreign Tax Credit may be your best option. In most cases, whatever excess paid in foreign taxes on your earnings beyond what you owe on your U.S. tax return may be carried back one year or forward for ten years. This could be beneficial if you are subject to a higher tax rate in the U.S. in later years or if you move to a foreign country with a lesser tax rate than where you live.
Credit plus Exclusion: Digital nomads who exceed the exclusion threshold may be able to use both. Let's assume you live in a foreign country with a 10% tax rate. If you earned $150,000 for the tax year, you should have already paid $15,000 in foreign taxes.
Yet, if the U.S. tax rate is 20%, you would pay $30,000 in taxes on your earnings of $150,000. With the Foreign Tax Credit, you can apply $15,000 of what you paid to another country against your U.S. tax liability of $30,000. That would leave you with a tax bill of $15,000 to the U.S.
Alternatively, you could exclude $107,600 of your $150,000 earnings on your tax return if you qualify to take the FEIE. This way, you only owe 20% taxes on $42,400 (which is $150,000 less the $107,600 excluded income). Your U.S. tax liability would now be $8,480.
If you have remaining earned income after excluding the full $107,600 of FEIE, you can still reduce your remaining U.S. tax liability further by exercising the FTC. This is done by the following formula:
(Taxable Income – Excluded Income)
Taxable Income
You can then multiply this percentage by the foreign taxes paid to come up with how much FTC you have available to deduct.
Using the figures above, the available FTC would be calculated as follows:
$150,000 – $107,600 = 28.3%
$150,000
Available FTC = $15,000 x 28.3% = $4,245
Your remaining U.S. tax liability is calculated as follows:
$8,480 (U.S. Tax liability) – $4,245 (Available FTC) = $4,235
Choosing between the FTC or FEIE, or some combination of both, can be complex. It is a good idea to speak with a tax professional who specializes in Expat Tax Returns.
Are digital nomads required to pay social security and medicare taxes?
In most cases, American digital nomads are required to pay Social Security and Medicare taxes. Since the FTC and FEIE only apply to income tax, not Social Security or Medicare, there is no exclusion or credit to reduce what you owe.
However, it is important to understand the requirements of the country you earn income in as the tax treatment can vary based on your situation.
Employed with a U.S. company:
Digital nomads employed by a U.S company are required to pay 6.2% of their wages (up to $137,700) for Social Security tax and 1.45% of their wages for Medicare. The U.S.-based employer will remit their matching portion.
Employed with a foreign company:
If the foreign company you work for has no requirement to withhold U.S. Social Security or Medicare tax, American digital nomads are not required to pay this in with their tax returns. However, if the foreign company is an affiliate of a U.S company, they are required to withhold Social Security and Medicare taxes from your check.
Self-employed individual:
American digital nomads are subject to self-employment tax regardless of where they earn their income. Through the SE tax, self-employed individuals pay 12.4% of their earnings (up to $137,700 in 2020) for Social Security and 2.9% of their earnings for Medicare. Along with federal income taxes, self-employed taxes may be remitted in quarterly installments during the tax year or paid when the individual files their tax return in the following year.
However, if you pay into the foreign country’s social security system or its equivalent, you may not have to submit U.S. self-employment tax if the host country has a totalization agreement with the U.S. A Totalization Agreement helps to eliminate dual taxation on the same earnings, and provide benefits for those residing in another country.
If the country where you earned income has a Totalization Agreement with the United States, self-employed digital nomads should request a Certificate of Coverage or a similar statement from the requisite agency in the foreign country. If you can’t obtain one from the country, then contact the Social Security Administration.
When you file your Form 1040, be sure to attach a copy of the certificate as well as write in “Exempt – see attached statement” on the line for self-employment tax.
Social security and medicare tax requirements can vary based on your tax situation and the length of time you are working overseas. It is helpful to speak with a professional who specializes in expat taxes.
Does it matter which state is considered my “domicile” in the US?
It does make a difference which state you consider as your domicile in the U.S. In addition to federal income taxes, many residents pay state and local taxes depending on where they live. The rules for what is considered income can vary from state to state. While most only require tax to be paid in on income earned in their state, some make it hard to prove.
Not every state charges tax. It may be worth becoming a tax resident in a state with no income tax. States like Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not have an earned income tax rate. Tennessee and New Hampshire only charge tax on investment income.
What is the Foreign Housing Exclusion?
American Expats may be able to further reduce their taxable income if they qualify for the Foreign Housing Exclusion. The good news is that if you qualify for the FEIE, there is a good chance you may exclude even more foreign taxable income. However, if you don’t meet the FEIE requirements, you aren’t eligible for the housing exclusion.
To be eligible for the Foreign Housing Exclusion, you must meet one of two tests.
- Be a bona fide resident of a foreign country for an entire tax year.
- Meet the physical presence test whereby you have physically been in foreign countries for at least 330 days during the tax year.
What Are the Requirements and Qualified Housing Expenses?
- It is not enough to qualify for the FEIE; you must claim that exclusion on your tax return. If you don’t, you won’t be eligible for the Foreign Housing Exclusion.
- You have qualified housing expenses. Rent, homeowner’s or renter’s insurance, furniture rental, parking rental, and repairs are considered qualified. Utilities, such as heat and water, are qualified, but payments for the internet or telephone services are not. Other non-qualified expenses include mortgage payments, furniture purchases, or housekeepers.
- You can only use housing expenses that were paid from employer-provided funds. For example, if you pay $2,000 in rent from your paycheck every month, you should include $24,000 in rent payments when calculating your Foreign Housing Exclusion. Conversely, if your employer pays rent on your behalf and doesn’t include this in your income, the payments will not qualify for exclusion.
- Your housing expenses must exceed a base amount, as stipulated by the IRS, before you can use the housing exclusion. And you can only claim the exclusion up to the maximum amount allowed in the location you live in. The base amount is currently 16% of the FEIE.
How do I calculate the Foreign Housing Exclusion?
Once you have determined that you qualify to take the Foreign Housing Exclusion, you will have to figure out how much of your housing expenses you can take on your tax return.
- First, compute your total qualified foreign housing expenses for the tax year.
- Determine the amount of FEIE that you will include on your tax return.
- Multiply the FEIE by 16% to determine your base amount.
- Your foreign housing expenses must exceed the base amount in order to receive the exclusion.
- Compare the excess of your foreign housing expenses to the location limit of your country of residence. Include the lower of the two on Form 2555.
The Foreign Housing Exclusion is calculated on Form 2555, along with the Foreign Earned Income Exclusion.
Can a self-employed American Expat claim the Foreign Housing Exclusion?
Self-employed digital nomads cannot claim a Foreign Housing Exclusion; instead, they will claim a Foreign Housing deduction. You’ll calculate the deductible amount in the same way as if it were being excluded. The primary difference is that Foreign Housing Deduction shows up on your 1040 Individual tax return to reduce your taxable income. Conversely, the Foreign Housing Exclusion is claimed on Form 2555. The Foreign Housing Deduction does not reduce your income used to calculate self-employment tax.
Keep in mind that if you claimed the home office deduction on your tax return, you can’t use any of these amounts when determining your foreign housing deduction.
Filing tax returns when you are an American Expat
The lure of traveling and working in remote corners of the world has its appeal. After all, you aren’t confined to a desk, and the view from your “office” could easily be a white sandy beach.
While the digital nomad lifestyle can take you just about anywhere, it doesn’t shed you of your tax responsibilities if you are an American Expat. In many respects, your tax filings may be far more complicated if you move around frequently or pay taxes to another country. American citizens and Green Card holders should seek the help of an experienced Expat Tax Accountant to ensure that they file their tax returns timely and get the full benefit of tax credits and exclusions available.