Foreign Earned Income Exclusion
So you have spent some time looking around 330days.com and you are sold.
You are going to go live and work somewhere overseas and even better, you are going to take full advantage of the foreign earned income exclusion to do it!
You are so excited you immediately call your parents, friends, family and post a status about it to all your various social media accounts.
They are curious and cautiously excited for you, but then they hit you with the question… “what in the world is the foreign earned income exclusion?”.
And, you give them the best answer you can…. “Well, ummm, it’s, ummm… you see…. Ummm I’m not totally sure but it has something to do with not paying taxes when you live in another country.”
Now your parents are concerned you joined one of those cults that believe paying taxes is unconstitutional and not really necessary (for real, they exist and frequently wind up in prison) and need an intervention.
Soon you are doubting the whole thing and your dreams of working from a beach in Greece are all but gone.
Knowledge is Power
You shouldn’t be expected to know the tax code inside and out and to memorize every tax strategy you are taking advantage of.
The IRS makes these things ridiculously complicated and the truth is that’s why you hire CPA’s like me, so we can know this stuff for you.
But when you are making a move as big as moving to another country and using a potential $100,000 tax write off as part of the justification I think it’s important that you have a very real understanding of how it all works.
As with anything else, knowledge is power. And in this case it may just be the power to calm your parents fears (I don’t care if you are 40 years or older, your parents will still likely be terrified when you tell them you are doing this!).
Let’s break this down into very simple terms.
So simple you can repeat it to your family, friends and anyone else concerned about you. And maybe even get them to want to join in!
The foreign earned income exclusion is the ability to not pay ordinary, Federal income taxes on up to $104,100 (amount as of 2018) of income earned while living and working overseas.
Here’s an example. You have an internet marketing business you can run from anywhere.
You decide to move to Costa Rica and work from the beach.
In 2018 you spend 343 days living in Costa Rica and the other 23 in the US. In that time, you make $175,000 profit in your business, with all actual work being done in Costa Rica.
Normally you would pay ordinary taxes to the IRS on all $175,000 of that profit (this is changing slightly under the new tax plan). But with the foreign earned income exclusion, you will only pay IRS ordinary taxes on $70,900.
This is a massive tax savings. Probably in the range of $15,000-$25,000 per year, depending on what your other income looks like.
What Taxes Do I Pay?
You may have noticed I highlighted the terms ordinary and federal when talking about the tax deduction.
So what taxes don’t qualify under those terms?
Basically you will still be paying state taxes (assuming you are in a state with an income tax) and social security/medicare taxes.
Let’s look at each:
State Taxes- Most states have an income tax, meaning they tax you on the income you make.
Unlike the IRS, they do not offer a foreign earned income exclusion.
Most states will still consider you a resident of their state if you aren’t making a permanent move out of their state. Places like California are super strict on this.
The good news here is if you do this right, you can establish yourself as a resident in tax friendly state prior to making the move overseas and avoid state taxes.
This could be another $5,000 to $10,000 saved in taxes, depending on your state. Check out our article on How to Pay $0 in State Taxes
Medicare/Social Security Taxes- If you have ever received a paycheck I’m sure you have seen the amount of taxes going towards social security and medicare taxes (about 7.6 percent).
If you own your own business, you probably know all about self-employment taxes (about 15.3 percent), which is simply paying both sides of the social security/medicare taxes.
Unfortunately, unlike with the state taxes, there’s no way to get around these ones.
You are going to have to pay these social security and medicare taxes, whether you are an employee or self-employed.
The only exception here would be if you are already paying the same version of these taxes to the country you are living in if that country has a tax treaty with the US.
But most of you won’t be doing that anyway.
So still plan accordingly on these pesky self-employment taxes even while qualifying for the earned income exemption.
What is Earned Income?
By now you are probably asking a very important question; what exactly is earned income.
To keep it as simple as possible, earned income is income that you are actively working for.
Here is a list of common forms of income that would not qualify as earned income:
- Interest Income
- Dividend Income
- Rental Income (as someone with rental properties I would love the IRS to explain to me how I’m not actively working for that money!)
- Capital Gains
- Profits from an S Corporation
Most of those are pretty self explanatory.
Interest income, dividends and capital gains are all pretty obvious ways to make income you aren’t actively working for. But take a look at that last one, profits from an S Corporation.
This is where a lot of people run into trouble when they do the foreign earned income exclusion.
Most people who are making enough money to take advantage of the FEIE are probably operating their business as an S Corp. And in an S Corp, you generally want your salary to be as low as legally possible to maximize the savings on self employment taxes.
The catch with the FEIE though is that S Corp profits, basically your earnings other than your salary, are considered passive income and don’t qualify for the exclusion.
So you want to be very careful to make sure you are operating out of the best possible entity and that your salary is structured properly if you are an S Corp. You will want that salary to be at least the amount of the income exclusion you would qualify for.
Check out our article on Picking the Right Entity for the FEIE
How Do You Qualify?
Now another important question, how do you qualify for this glorious tax deduction? Well, there are two ways.
- You become a resident of another country.
- Meet the 330 day test.
You probably aren’t going to become an actual resident of another country unless you are planning to stay there long term.
So your best bet is to meet the 330 day test.
The 330 day test says that you have to be in a foreign country or countries for 330 full days during a 12 month period.
This 330 full day rule is extremely strict. There are no exemptions given if you have to return to the states for illness, family emergency, work requirements or basically any other excuse you can think of.
The only exception they give to cutting short on the 330 days is if there is war or civil unrest where you are staying.
And when the IRS says full day, they mean FULL DAY. It has to be 24 consecutive hours to count. So if you arrive in France at 10am on January 17th, your first full day won’t start until January 18th.
Your flight could change things here as well. If you fly over another country in route to your destination, your first full day will begin the next day, even if you have not arrived.
So if you are flying to Spain and pass over France at 10pm on January 17th, but don’t arrive to Spain until 12pm January 18th, your first full day still counts as January 18th.
Finally, international waters will not count as being outside of the United States.
All in all, this should tell you to plan your 330 days very thoroughly.
Does it Have to be a Calendar Year?
While the IRS is incredibly strict on the 330 full days, they are far less strict on when the 12 month period begins and ends.
It can basically be any 12 month period, whether it is a traditional January 1 through December 31, or any random months, like September through July.
The one thing to note here though is only the income you earned while you were overseas will qualify for the exclusion. So if you don’t start it until March, any income made through February will still be fully taxable.
Do You Have to Stay in One Country?
Some people love adventure way too much to be tied to just one country. Good news! You don’t have to be.
The foreign earned income exclusion allows you to spend those 330 days in any mix of foreign countries you want.
The thing to be careful of here is that you absolutely have to diligently track what days you were in which country. As with anything when it comes to the IRS documentation is king.
Hopefully this helped you get a firm grasp on the foreign earned income exclusion. You should fully confident telling Mom and Dad and any other concerned person in your life what you are doing and what the tax benefits are.
Here’s a quick summary to hit them with the highlights:
- By spending at least 330 full days in a foreign country you will qualify for the foreign earned income exclusion.
- This will allow you to not pay ordinary, federal taxes on the first $104,100 of earned income made while living overseas.
- A full day starts the first 24 hour period you are in a foreign country.
- You can move around from country to country but must thoroughly document dates and locations.
- You still have to pay state taxes (unless you follow our advice) and self-employment taxes.
That’s it. That should do the trick. If you hit them with all those facts and they still think you are being scammed, well, it’s time to find more supportive people in your life 🙂
Be sure to check out our other articles detailing other parts of the foreign earned income exclusion and how to best utilize it.