When people first find out about the foreign earned income exclusion and are adding up all the massive tax savings they are in line for as a result of living out of the country for at least 330 Days, they are often surprised and disappointed to learn that those tax savings do not apply to state taxes. If the IRS allows you to write off over $100,000 in taxable income surely the states will follow suit, right?
Unfortunately the Federal and State governments operate on entirely different tax rules. And while the state taxes are typically considerably lower than the IRS taxes, it’s still a good chunk of money you are paying to not live in that state for 330 days or more a year.
Especially in a state like California, who could charge you at and above 10 percent of your taxable income in state taxes.
So what can you do? Is there any way out of paying these state taxes? The answer is yes, with a little planning you can absolutely get rid of these state taxes. And not just on the first $104,000 in income like with the IRS.
By following our plan below, you can get rid of those state taxes on all of your income.
The answer is to establish residency in a new, more tax friendly state, before making your move outside the country.
How to Establish Residency
If getting rid of state taxes is as simple as becoming a resident of a new state, the obvious question here becomes how do you become a resident of a new state?
In the all-time great TV series The Office (it’s OK if you don’t agree that The Office is an all-time great show. You are perfectly entitled to your own wrong opinion on such matters) Michael Scott is going through some major financial difficulties. One of his employees, Oscar, advises him to declare bankruptcy to help ease the burden of all the debts he has racked up. Michael agrees with the plan, stands up, and literally declares bankruptcy, yelling outloud “I declare bankruptcyyyyyy”. His friends have to inform him it’s not a literal out loud declaration.
Unfortunately becoming the resident in a new state isn’t quite that easy either. You can’t just tell your old state you have become a resident of a new state and wish them the best. You have to actually become a resident of that new state first.
So how do you stop residency in one state and start residency in another? Here’s a full list of everything I want you to do. And since you will want this to be done before you start your out of country, 330 Day Challenge be sure to give yourself plenty of time to make it all happen.
Sign a Lease in Your New State- The best way to show you are a resident in a certain state is to actually have lived in that state. The easiest way to prove that is with an actual lease on a place to live. This can be a short term, three month or so lease of an actual apartment or home or it could even be leasing a bedroom from a friends place. But if you go with the latter, be sure to still have a written lease agreement to prove you lived there.
Get a Drivers License in Your New State- This is another great way to prove you are an actual resident of a state. It’s pretty hard to argue that you aren’t a resident of the state your drivers license says you are. To do this you will almost certainly need to have done step one above first. They want you to actually live in the state before becoming a resident.
Close All Living Ties to Old State- If you want to end your residency and therefore your tax obligations to your old state, like California for example, the biggest thing you need to do is close your ties there. Most importantly, don’t have a place you are living there. Make sure you close your lease agreements there. If the state thinks you still live there because you have a home there, they will expect their share of taxes.
Don’t take any chances. If you want to do this right, cut your ties to the old state.
If you follow those three steps before embarking on your out of country journey you could ensure you pay little or even no state taxes. But which state is best?
Choosing the Best State
There are currently seven US states that do not charge a state individual income tax. They are:
While they all offer the same overall no individual income tax, some are more attractive than others. Some enforce a business tax even on pass through entities (TN and NH). Some have higher setup and maintenance fees than others (NV can get hefty on fees). So all things considered, which state should you choose?
Well this is one of those decisions that you will really want to look at your own personal situation and talk with an expert about it. But for most people, I would be choosing between Texas and Florida. We have found those both to be fairly inexpensive to set up and maintain and incredibly tax friendly to both individuals and businesses.
One important thing to remember when choosing a state, if you are only doing this while you are out of the country, you don’t need to factor in much how much you actually like the state. You will only be actually living there very short-term. Look at the tax ramifications first and foremost.
Establishing residency in a tax free state is a fantastic way to supercharge the tax savings with the foreign earned income deduction. It could save you tens of thousands of dollars if done right. But this isn’t something to be taken lightly. Carefully consider the right state for you and then plan long before your move overseas to set it all up.
Some of these high tax states really like their tax dollars and they will try everything in their power to treat you as a resident there (*cough* California *cough*). By taking the steps we talk about here and planning ahead, you can ensure you escape the long arm of the high state income tax collectors!