Imagine someone told you this…
I’m going to make you a deal.
For the rest of your life, I’m going to be your silent partner. You’re going to pay me 20% of everything you ever make. Forever.
In return, I’m not going to do anything. I won’t add value to your life or your business. In fact, I’m actually going to be destructive.
For the rest of your life, I’m going to make you fill out a bunch of stupid forms. If you own a business, I’m going to make you hire employees that you don’t need and incur all sorts of costs just to handle all the excess paperwork.
And because I’m your partner, people all around the world won’t want to do business with you. You’ll definitely miss out on all sorts of opportunities because I’m your partner.
Of course, should you decide that you don’t want to pay me my fair share anymore, I’ll send a bunch of goons to drag you out of your home in the middle of night at gunpoint and throw your ass in jail.
And if you want to terminate this relationship altogether, you have to pay me a huge sum up front.
Sounds like a great deal, right?
Of course, no rational human being would ever willingly enter into such a one-sided, ruinous financial relationship.
But this is precisely what taxes are– a completely one-sided, ruinous financial relationship that we’re stuck with by accident of birth.
Everyone knows how draining taxes can be to their personal finances, and an entire industry exists to help people reduce their tax burdens.
Some of these tactics are completely irrational. In financial markets, people often deliberately sell stocks at a loss simply for the tax benefit. Or they’re forced to set up incredibly complex and expensive structures just to ensure the government doesn’t take half of their stuff when they die.
Tax mitigation strategies are important. In a zero interest rate environment where returns paid by most bank deposits, money market funds, and government bonds fail to keep up with inflation, cutting your tax bill can be one of your best returns on investment.
Think about it– if you can save 20% on your taxes, it puts as much money in your pocket as making a 20% investment return. (actually more like a 25% investment return… because you get taxed on your capital gains…)
Earlier this week I briefly mentioned one strategy known as the Foreign Earned Income Exclusion (often called the foreign income tax exclusion).
This is a way for you to earn up to $102,100, tax free. And if you include your spouse and housing benefits, the tax-free earnings can easily exceed $250,000.
How the Foreign Earned Income Exclusion works
US citizens are taxed on their worldwide income no matter where they live. (This is almost entirely unique to the Land of the Free).
If you’re a US citizen living in Bangladesh and earning money in Pakistan, and you’ve never set foot on US soil, Uncle Sam still expects its fair share of your income.
The key exemption, however, is that non-resident US citizens (i.e. Americans living abroad) can earn up to a certain amount each year, tax free.
This amount varies from year to year. In 2015, for example, the exclusion was $100,800. For 2016, it increased to $101,300 and for 2017 it’s up to $102,100.
This means you can earn over $100,000 in income while living overseas and not have to pay a dime of income tax on those earnings.
To be clear, the IRS is very particular what qualifies as ‘earned income’. This includes things like salaries, commissions, bonus income, and professional fees, as well as certain allowances and reimbursements like cost of living allowances and moving expenses.
(It’s also possible to set up a business overseas and receive a salary which would be exempt from US individual income tax.)
How to qualify for the Foreign Earned Income Exclusion
One of the primary qualifiers to claim this benefit is that your ‘tax home’ must be in a foreign country. And the IRS has two ways for you to demonstrate this.
First is what’s called the Physical Presence Test. In order to qualify, you must have spent 330 full days outside of the United States in a 12-month period, i.e. you can only be in the US for 35 or 36 days in a year.
Note- “full day” means a consecutive 24-hour period from midnight to midnight. So if you depart New York today and arrive to London tomorrow morning October 25 at 10am, your first ‘full day’ won’t be until Sunday.
The other way to qualify for the exclusion is to be a ‘bona fide resident’ of a foreign country for an entire tax year.
This is a much more subjective approach than simply counting the days you spend outside of the US.
Through this test, the IRS looks at a number of circumstances. Are you really living overseas? Do you have a home, bank account, and local ties to a foreign country? Are you a legal resident, or at least going through the process? Is your family living with you?
Even more important– do you maintain a home in the US? Do you stay there when you’re in the US? Are your household goods and personal property still in the US?
Unlike the physical presence test, qualifying under this bona fide residency option means that you can spend more than 35 days in the US… so there’s a bit more flexibility to spend time with friends and family.
And again, both you AND your spouse can qualify, meaning EACH of you can exclude $102,100 of your foreign earned income. This can potentially save you $43,018 or more in federal tax.
Taxes are an enormous benefit of living overseas. Your life can be MUCH richer. In addition to having more freedom and greater lifestyle opportunities, you can save a boatload of money… and stop financing war.
It’s definitely something to consider.