What if I told you there was a way to travel years on end and pay little to nothing in income tax?
It’s called the Foreign Earned Income Exclusion and it’s how savvy digital nomads are able to save thousands of dollars per year on their tax returns.
Click here to find out if you qualify or keep reading to learn more.
What is it?
Most countries in the industrial world do not tax their citizens on money they’ve earned while living in a foreign country.
The USA is an exception.
Unlike most of the rest of the world, the United States taxes its citizens living abroad.
That means if you live in a foreign country you could end up paying income tax twice, once to your host country, and once to your home country.
Fortunately there’s a way around this, and it’s called the Foreign Earned Income Exclusion.
(We’ll call it the FEIE for short).
The United States realized that taxing citizens abroad puts them at a severe economic disadvantage to citizen workers from other nations, so they implemented the FEIE in order to help US citizens stay competitive in the global workforce.
The FEIE makes your first $101,300 of income each year tax free.
The FEIE is a waiver on the first $101,300 you earn for every year you live abroad, and this number is adjusted for inflation each year so it will just keep going up with time.
Of course, your commensurate spending power will decrease accordingly, but hey, at least that’s being accounted for.
Most people who qualify for the FEIE live full time in a foreign country and pay income taxes to that country instead of US Federal income tax.
But for some digital nomads who don’t establish a new tax home outside of the US, it means they aren’t required to pay income tax anywhere!
Photo by Ross Parmly on Unsplash
Do you qualify?
There are two ways to qualify for the FEIE:
- Establish residency in a foreign country.
- Don’t step on US soil for more than 35 days in a 12 month period.
If you travel for an entire year primarily outside the USA and don’t establish residency in any other country requiring you to pay income tax, then you are not liable to pay income taxes on any of your first $101,300 in income for that year!
At an effective tax rate of 18.05% you would save over $18,000 dollars for that year, not even considering state taxes.
(You do still need to file).
Most states recognize the FEIE as well, leading to a potential savings of several thousand dollars more on your state income tax.
For many people these savings are more than enough to fund their travels.
Notable exemptions to this rule are New York and California which may still require you to pay state income taxes.
Some digital nomads get around this by establishing residency in another state before leaving the country, thus allowing them to continue avoiding income tax entirely.
Establishing residency is a quite a bit harder than simply staying outside of the US, but has the added benefit of allowing you to visit the US as much as you want!
We’ll come back to the details of establishing residency later.
It’s Great to be a Modern Digital Nomad
The best part about this income tax exemption is that it includes money made from USA companies. This is great news for remote workers living abroad.
It means that you can earn income from a company based in the USA, travel the world for the entire year, and potentially pay nothing in income taxes on the money you earned.
Some argue that it is not right to avoid paying income tax just because you are traveling. At first glance, it seems unfair to those of us living at home.
But think about what income tax is for: services like roads, infrastructure, and government programs.
Things that you mostly cannot take advantage of while traveling.
Therefore, does it really make sense to pay for services that you can’t use?
The existence of the FEIE indicates that the government agrees with this viewpoint and the IRS does not think that people living abroad should be obliged to pay for services they do not have the ability to use.
Photo by Sara Rozic on Unsplash
What’s the Physical Presence Test?
The easiest way to qualify for the FEIE is by spending no more than 35 days inside in the United States. That’s the physical presence test and it’s how digital nomads can save a ton of money on their taxes.
Claiming this exemption as a digital nomad can be fairly straightforward.
As long as you strictly obey the 35 day rule, you should qualify. But be warned: there is absolutely no leeway to this rule.
If you spend even one minute in the USA, it counts as a day.
This also includes anytime spent flying over US airspace and it even includes time spent in international waters. If you aren’t in any country for a period of 24 hours (for example, if you’re on a cruise ship) it won’t count for you as a day abroad when you file your taxes.
You are responsible for keeping track of days spent in the USA and being able to prove that you spent no more than 35 day inside of the country.
It’s important that you keep at least a couple days buffer in your travel plans, otherwise short flight delay could end up costing you thousands of dollars.
This information is reported by keeping track of when you entered and exited the country. It’s vitally important that you keep a record of all flights and other border crossings as well as documenting proof of your itinerary.
You need to store this information somewhere safe, as the IRS won’t check your tax return for up to two years after you file.
Meaning, they could audit you several years down the line, then find you in violation and charge you not only back income tax, but fines, and interest on top of that unpaid tax.
As long as you keep good records and make sure to stay under the 35 day limit, you should have no problems claiming and keeping your tax break.
What is a Bona Fide Resident?
So we’ve established that it’s straight forward to claim the exemption as a digital nomad who isn’t putting roots down in any one country and who is okay with infrequent visits to the USA.
But what about those of us who decide they do want to live full time in a foreign country and still come back to the USA?
Once you establish residence in a foreign country, the 35 day travel ban is lifted and you can visit the USA as often as you please as long as you maintain bona fide residency in that foreign country.
A bona fide resident is a US citizen who legitimately resides in a foreign country.
Bona fide residency is a term defined by the IRS to determine whether you really live in a foreign country, and qualify for the exemption, or if you actually live in the USA, and should continue paying for the services you receive here.
Do I Qualify as a Bona Fide Resident?
In order to help you answer this question I’ve created a free online tool that will walk you through the questions the IRS asks and help you determine whether you can qualify for the FEIE. If you do not qualify, the tool will make suggestions to help you adjust your situation so that you do qualify.
Find out if you qualify for the foreign earned income exemption.
Legal disclaimer: I am not a lawyer or an accountant and I make no guarantees about the accuracy of the tool. Please use at your own discretion. You are responsible for determining the accuracy of your taxes.
Here are the primary factors which the IRS will consider:
The nature of your work
If you are in your host country on a contract basis with a defined end point, then you probably won’t qualify.
If you work for the United States Government or Military then you automatically do not qualify.
Where you live
If you live in housing that is provided for you by your employer or if you live in a student dormitory, then you most likely won’t qualify.
However, if you provide your own housing, either by renting or buying, you are more likely to qualify.
Where your family lives
If they live with you in the foreign country, that’s a good sign you will qualify for the exemption.
However, if they live back in the United States, it’s less likely.
This is especially true if they live in a home you own and maintain there.
Where you pay tax
If your paying taxes to your host country then you’re more likely not to be required to pay taxes to the USA.
What kind of Visa you have
If your Visa limits the length of our stay in the host country, and can’t be easily renewed, then you won’t qualify as a bona fide resident.
Conclusion
For bona fide residents, the IRS is ultimately trying to determine whether you have plans to move back to the United States or not. In other words, whether you’re just visiting a foreign country, or whether you actually live there.
They consider every case individually and on a slow timeline, so you really want to make sure you fit their mold as perfectly as possible to avoid being denied years after you made your claim.
On the other hand, if you’re able to avoid travel to the United States, or if you just love the nomadic lifestyle, it’s actually very straightforward to save thousands of dollars.