Journal of Financial Planning: October 2023
Bryan Kirk is director of financial planning and estate planning for Fiduciary Trust International (www.fiduciarytrust.com), a global wealth management firm headquartered in New York, NY.
The modern digital nomad comes in many varieties. They may be making a video call from a Munich apartment, sending emails from the beach in Bali, writing code on a train across Canada, living and writing about the #vanlife in Chile, or leading an executive team remotely from Seoul. With the normalization of remote work, financial advisers are much more likely today to encounter U.S. citizens living and travelling abroad while continuing to work across a range of careers and industries.
Still U.S. Taxpayers
The first reminder for any digital nomad is that they are still U.S. citizens. Assuming they were U.S. citizens to start, adopting the nomadic lifestyle and living abroad—even if they never intend to set foot on U.S. soil again—does not change their status as U.S. taxpayers.
For tax purposes, being a U.S. citizen means taxation on their worldwide income. No matter where you earn income, it is subject to U.S. tax if you are a U.S. citizen. In addition, gifts and estates of U.S. citizens are subject to tax worldwide. For the wealthy digital nomad, simply living abroad does not remove them from the U.S. gift and estate tax system.
Other than Eritrea, United States is the only country to tax its citizens based only on their citizenship. As a result, advisers should not assume clients—in particular, digital nomads living abroad—are aware of the U.S. rules.
In some ways, the United States’s worldwide taxation simplifies the discussion, but it should be the starting point of your conversation in any case. Always confirm the citizenship of a new or potential client. They may think establishing residency or becoming a citizen in another country breaks off their U.S. status. But giving up U.S. citizenship (and taxation) requires formal renunciation and isn’t broken by any oath or action you take related to another country.
Foreign Accounts and Gifts
U.S. taxpayers must report foreign bank or financial accounts to the U.S. Financial Crimes Enforcement Network (FinCEN) via a Report of Foreign Bank and Financial Accounts, also known as an FBAR. The requirement applies if the aggregate value of your accounts at any point during the year exceeds $10,000.
Individuals living abroad typically will have one or more foreign accounts. It’s critical these accounts are reported. Civil and criminal penalties can apply for FBAR violations. For a non-willful failure to file, a penalty of $10,000 per report can apply.
Individuals with foreign investment accounts also need to be mindful of the rules around passive foreign investment companies (PFICs). Overseas investments may fall into these complicated rules, so the best approach is to ensure they are consulting with their U.S. tax advisers before making the investment.
In addition, U.S. taxpayers must report to the IRS gifts or bequests from a non-resident alien over $100,000 as well as certain transactions with foreign trusts. These types of transactions become more common when individuals reside abroad—in particular, when non-citizen family members are part of the picture. Stiff penalties again apply. For an unreported gift, the penalty can go up to 25 percent of the gift amount.
Managing Income and Deductions
Aside from reporting on foreign accounts and gifts, from the U.S. perspective, tax planning for a U.S. citizen living abroad is largely the same tax planning you would do for someone living in the United States. Yet there are several areas that deserve special attention:
Foreign earned income exclusion. U.S. citizens are generally all taxed on their worldwide income, but there is an option to exclude foreign earned income. For U.S. citizens, the exclusion can apply if they are a bona fide resident of another country or countries for the entire tax year or for 330 days during a 12-month consecutive period. Income can count as foreign earned even if their employer is in the United States and funds are deposited in a U.S. account. The key factors are where they provide the services being compensated and their tax home being another country. In 2023, a $120,000 limit applies to the exclusion. Taxpayers also can’t claim deductions related to the income they exclude.
For an example, if you lived in India for all of 2022 and earned $100,000 for work you performed for your company based in San Francisco, you could exclude that entire amount from your U.S. taxable income. You may seek a refund for any tax withheld from your salary; alternatively, you could proactively inform your employer to stop withholding, using IRS Form 673. The exclusion is not available for unearned income, like you might receive from a business independent of your services, but there is also an exclusion for employer-provided housing.
Once you elect the exclusion, it is in effect until you revoke it. If you revoke it, though, you must request IRS approval to reinstate if you’re within five years of your election. Ideally, when electing the exclusion, you have a sense of what your future income and residency will involve. This may be hard for a nomad living a more transient lifestyle, but the effort is worthwhile to avoid an unintended tax situation.
Expense records. Clients should know they need to maintain records of any deductible expenses. This may pose a challenge in a foreign country where different cultural practices prevail. They may need to handle certain business expenses in cash or with vendors not set up to provide familiar forms of receipts. If they have receipts, they are likely in other languages and currencies. Clients should not expect to claim deductions for payments not supported by proper records. Instead, they should make the extra effort to maintain support for all expenses and be fastidious in tracking how it transfers to their tax reporting.
Retirement savings. Clients living abroad with excess income can and should still be contributing to a U.S. retirement plan. Self-employed individuals may consider creating a SEP IRA or solo 401(k). Logistics generally are not more difficult than if done from a domestic base. The thing to catch is the income requirements and limitations must take into account any foreign earned income exclusions.
For example, if an individual has $100,000 of foreign earned income and elects the exclusion as in the example above, they would be left with no U.S. income to contribute to a plan. Alternatively, if they had $140,000 of income, the exclusion would only apply to $120,000 of income in 2023. That would leave $20,000, the bulk or all of which might be contributed to a U.S. retirement plan to eliminate their U.S. income.
Retiree spending. Retired nomads often have a simpler picture since they no longer have earned income to manage. But they (along with their working brethren) still can time their income and deductions to optimize their taxes year by year. This typically involves deferring income or accelerating deductions. It also can involve Roth conversions, installment sales, and tax loss harvesting. These items don’t change when living abroad. But nomads on the move should evaluate income and deduction timing based on local tax rules and any shifts amid other jurisdictions imposing tax.
A retiree about to start traveling abroad for an extended period may consider or reconsider deferring income from a property sale depending on how the later recognition of the income will interplay with their international position. Similarly, they should be evaluating their spending patterns between their taxable brokerage account, tax-deferred 401(k), and tax-free Roth IRA to match the optimal result for their full international tax picture.
Charitable giving. In relation to charitable giving, nomads may be inclined to give locally in other countries. But contributions to foreign organizations are not deductible under Internal Revenue Code 170. Instead, individuals should seek out U.S. organizations doing work in the other countries, keeping in mind that many foreign organizations have U.S.-based affiliates designed specifically for that purpose. Advisers can use the IRS’s exempt organization search tool to determine if an organization qualifies.
Extensions. U.S. taxpayers with a place of business outside the United States can qualify for an automatic two-month extension from the April 15 deadline and may request an additional two-month discretionary extension from the extended October 15 deadline. This may be helpful when awaiting information from jurisdictions not reporting on the same schedule as the United States.
Local (Foreign) Tax Rules Can Apply Too
The complexity of the nomad’s situation often arises from the local jurisdiction. Individuals (and their advisers) need to understand the tax rules of any place where they may live, earn income, or have property interests.
Tax systems vary widely. National, provincial, or territorial and local taxes can apply. What we call taxes may be called duties or other terminology and may be applied to different types of property interests, events, transactions, or definitions of income. The safe approach is to make no assumptions other than that various forms of taxes may apply and the client has an affirmative responsibility to figure it out.
As an example, something as basic as a revocable trust can have drastically different tax consequences in other jurisdictions. In the United States, a revocable trust is nothing to think about for tax purposes. Yet even in a country as closely related to the United States as the U.K., a revocable trust can be treated as a separate taxpayer and require significant tax payments based on the movement of the trustee if it is deemed a U.K. resident.
Tax Treaties and Credits
Assuming the client works through their U.S. responsibilities and figures out their responsibilities to any other jurisdictions, tax treaties and credits also come into play.
The United States has tax treaties with over 60 countries. These treaties may address income taxes generally, or particular types of income. Treaties may provide rules to determine primary taxing authority, as well as residency or domicile determinations. In addition, the United States has bilateral Social Security totalization agreements with certain countries. If one of these treaties applies, a self-employed individual may only need to worry about Social Security in the country where they reside.
The United States is also a party to 17 gift and estate tax treaties, as well as the income tax treaty with Canada that relates to U.S. transfer taxes. These treaties are crucial for the wealthy nomad to understand if they are deciding to make their base in a country depending on how they will ultimately transfer their wealth. The treaties are generally designed to avoid double taxation, but depending on the countries involved, there can be situations where the total tax exceeds the U.S. estate tax rate of 40 percent. They may also have property that needs to be reported in different countries, with resulting taxes that may require international transactions and entity logistics to cover.
Independent of any treaty benefits, individuals may be able to take either a credit or an itemized deduction for taxes paid to a foreign country or U.S. possession based on income also subject to U.S. tax. In general, only income taxes qualify. In addition, only the actual tax liability to the foreign government qualifies—as opposed to tax withholdings or other refundable payments. This is not available for taxes on excluded foreign earned income.
For example, if you pay $20,000 in foreign taxes based on $80,000 of foreign earned income, you could elect to exclude the income. In that case, you could not claim a credit or deduction for the foreign taxes. Alternatively, you could not exclude the income, report it on your U.S. return, and claim a tax credit for the foreign tax. This would likely make sense in this scenario where the foreign taxes are higher than the U.S. amounts.
State Domicile
In addition to the U.S. federal rules and the rules in the foreign jurisdictions, U.S. citizens living abroad need to consider taxation at the state and local level in the United States.
When you leave a U.S. state and stop filing taxes with the state’s tax authorities, the state will often look for the reason why. If an individual has fully moved out of a state and no longer has any income arising from a source in a state, there may no longer be any connections to give rise to state level taxes.
But digital nomads often retain a U.S. base. As an example, an individual may have their mail sent to a friend’s house in San Francisco and may use the address to register and keep their car. As the house of a friend, they may argue it was never and isn’t their own home. But if it was their parents’ house or a house they still own but are leaving vacant after living there for years, the argument may be harder to make.
All these facts can matter as states look to determine an individual’s domicile for tax purposes, unlike residency, which depending on the state may be determined by a bright line rule related to numbers of days in a state. Domicile typically involves a more subjective test of the place a person considers their home. While some digital nomads may have given up on the concept of the home, state tax authorities still will look for it and properly seek to tax those nomads for whom home remains in the United States.
Lastly, Expatriation
An article about digital nomads wouldn’t be complete without a word about expatriation. For a range of reasons, interest in expatriation often arises for individuals who have been living abroad for an extended period and perhaps don’t see much likelihood of ever coming back to the United States.
The short answer to the expatriation question is usually it doesn’t make sense. The reason for this is the U.S. exit tax. The exit tax requires an individual to pay taxes as if they sold all their assets on the day before they expatriate. The tax applies if any of the following apply:
- Average annual net income for the five previous years is more than $190,000 (2023 threshold, adjusts for inflation)
- Net worth is $2 million or more
- The taxpayer fails to certify they have complied with all U.S. federal tax obligations for the five previous years
There are also special estate tax rules that apply to individuals who fall in one of these categories.
For some, the U.S. exit tax may not be a concern. But it’s often enough of a deterrent along with the various benefits of U.S. citizenship to incentivize someone to remain a U.S. citizen and comply with the rules outlined in this article.
The Right Team of Advisers
As the foregoing should make clear, it’s essential for digital nomads to surround themselves with competent professionals. This starts with a U.S. accountant with experience working with clients living abroad. Experienced local tax advisers in the relevant foreign jurisdictions are also needed.
Financial advisers should be cautious about clients relying on foreign tax advisers to advise on a U.S. citizen’s complete picture. U.S. tax rules may be counterintuitive for practitioners in other jurisdictions, and vice versa. Financial advisers also should be cautious about clients trying to manage tax advisers in multiple jurisdictions without the tax advisers communicating directly. That is a task ripe for mistakes and missed opportunities.
Individuals should seek to have a single adviser coordinating the tax reporting across their jurisdictions. While some larger accountancy firms are capable of handling this, more often one of the tax advisers will need to take the lead. Some financial advisers may be able to play this role as well, provided they are clear on the boundaries between coordination, tax advice, and reporting responsibilities.