As a self-employed freelancer who has the option to travel the world (otherwise known as a digital nomad or expatriate), you get unlimited earning potential, ultimate work flexibility and your choice of office locations across the globe...but what about paying taxes to Uncle Sam? That’s right — working in Uruguay, Bali or Thailand doesn’t excuse you from paying your U.S. taxes.
If you’re new to the digital nomad life, taxes for expats working remotely can feel overwhelming. Don’t worry — we’ve got you covered on everything you need to know about your tax responsibility as an expat or digital nomad. In this guide, we’ll walk you through how to pay U.S. taxes when you’re working abroad.
Digital Nomad Income Taxes
If you’re a U.S. citizen or resident alien, you’re subject to paying federal income tax on worldwide income. What qualifies as worldwide income? Any work you did while living in another country. Even if your employer is based in the U.S. and your income was deposited into a U.S. bank, the money you earned while physically in another country is considered worldwide income. As a digital nomad living outside of the U.S., you do have some options to help reduce your income tax bill.
Foreign Income Exclusion
Through the Foreign Earned Income Exclusion (FEIE), you may qualify to exclude up to $108,700 of your foreign earnings for 2021. On top of that, you may be eligible to exclude the value of meals and lodging provided by your employer from your income as well.
There are two major requirements to qualify for the Foreign Earned Income Exclusion:
You need to establish a “tax home” in at least one foreign country. The IRS considers your “tax home” to be the main place of your business or employment, and it is looking for proof that your “abode” is truly outside the U.S. The easiest way to do this is to end your office lease, move out of your apartment, sell/rent your house or sell your car. Essentially, anything that provides written proof that you indicate to live outside the country at least semi-permanently.
You’ll need to satisfy either the Physical Presence Test or the Bona Fide Residence Test. According to the IRS, you meet the Physical Presence Test if you are physically present in at least one foreign country for 330 full days during a 12-month period. While the 12-month period needs to be consecutive, the 330 full days do not. You can meet the requirements for the Bona Fide Residence Test if you are a bona fide resident in at least one foreign country for an uninterrupted period that includes one tax year. Note that just working in another country for a year doesn’t necessarily mean you’re a bona fide resident. For instance, if you decide to work remotely from Costa Rica for a few months and then go to Iceland for a change of pace, you won’t establish a bona fide residence. But if you go to Costa Rica to work for an extended or indefinite period and set up a residence for you and your family, you likely will have established a bona fide residence. This remains true even if you intend to eventually return to the U.S.
Foreign Tax Credit
Some digital nomads may need to pay expatriate taxes in their host country. If you find yourself in this situation, the Foreign Tax Credit will help ease this tax burden by allowing you to either claim a credit or deduction against your U.S. taxes. The key point to remember, however, is that you cannot claim a foreign tax credit and file for foreign income exclusion. You must choose one or the other, and in the process, you need to weigh which option would best benefit your tax liabilities.
Your foreign tax credit is determined by the amount of tax you pay or accrue while you are living abroad. If you choose to go with the foreign tax credit, you have two options: 1) Use it as a credit against your U.S taxes, effectively reducing your U.S. tax liability, or 2) take it as a deduction, which will then reduce your U.S. taxable income.
Foreign Housing Exclusion or Deduction
Expats and digital nomads living outside of the U.S qualify for the Foreign Housing Exclusion or Deduction if they satisfy the Physical Presence Test or the Bona Fide Residence Test (both outlined above). Once that's established, and you have shown that you've earned foreign income, you can deduct anything over 16 percent of your maximum foreign earned income and apply it toward your foreign housing deduction. (Housing expenses can include rent, utility bills, furniture rental or garage fees, but do not cover the cost of buying property or home improvements that appreciate the value of a property.)
According to the IRS, the amount considered as your foreign housing amount is the total of your foreign housing costs for the year minus the base housing amount set at 16 percent for 2021. So for some easy math, consider the following:
If your housing expenses for the year come up to $40,000, you are $23,000 above the 16 percent base housing amount of $17,000. Anything over that $17,000, which for this example amounts to $23,000, can go towards your foreign housing deduction.
Do Expats Pay State Taxes?
So we’ve established that U.S. citizens living abroad will still need to file federal income taxes, but what about paying state taxes? When it comes to individual states, the answers will vary and depend on each individual nomad's situation. Still, some general questions to consider when it comes to the filing of state taxes include:
Do you still own property in the state?
Do you collect income from investments and businesses based in the state?
Do you visit the state for extended and frequent spans of time?
Do you spend large blocks of your time while visiting the state working or conducting business?
One more important consideration is whether or not the state you once resided in even collects state income tax. If you moved from Alaska, Washington, South Dakota, Wyoming, New Hampshire, Tennessee, Texas, Nevada or Florida, you would not need to file for state income tax because these states do not collect it. In fact, you don’t even need to show that you are working abroad.
If, however, you live in any of the other 41 states, you will need to check with your Secretary of State website or consult with a tax preparer. But for the most part, if you keep to the bulleted items above and do not have any significant ties to the state, you will not need to file state taxes.
Do Digital Nomads Pay Self-Employment Tax?
If you’re an independent contractor who receives a 1099-NEC from a client, you might still be subject to business taxes such as the self-employment tax, which is made up of Medicare and Social Security taxes.
A self-employed digital nomad is subject to paying higher self-employment taxes than someone who worked for an employer. This is due to the nature of Medicare and Social Security taxes: When you work for someone, the employer pays half of these while you (the employee) are responsible for the other half. But when you’re self-employed, you’re considered both the employer and employee, so you need to pay all of these taxes.
For the 2021 tax year, the Social Security tax rate is 6.2 percent for both the employee and employer. If you’re self-employed, that means you’ll need to pay 12.4 percent. However, you only pay Social Security taxes on the first $142,800 of your earned income.
The Medicare tax rate is 1.45 percent for employees and employers, so as a self-employed digital nomad, you’ll need to pay 2.9 percent. Unlike Social Security taxes, there’s no cap on earned income; you’ll need to pay that 2.9 percent, no matter how much you make. (If you are a high earner, you’ll need to pay an additional Medicare tax of 0.9 percent on any income above $200,000, or over $250,000 if you’re married.)
How to Lower Your Taxes As a Digital Nomad or Expat
One thing you can do to reduce your self-employment taxes when working remotely is set up an LLC and elect to tax it as an S Corporation. By setting up your business this way, you can classify some of your earned income as salary and some as a distribution. You'll only pay self-employment tax on the portion designated as salary. The money designated as a distribution avoids self-employment tax and instead only pays standard state and federal taxes.
This can save you quite a bit of money. How much, exactly? Let’s say you set up your business as a standard LLC. If you took $70,000 out of the business, you would pay $10,710 in employment tax (15.3 percent). But if you took out $45,000 as a salary and $25,000 as distributions, you would pay only $6,885, saving you $3,825. You can use our handy tax calculator to see how much you could save on self-employment taxes by setting up your business to be taxed as an S Corp.
We know taxes can be difficult, whether you're a digital nomad or not. Incfile offers a complete Accounting and Bookkeeping service. We'll take care of all your accounting and tax needs so you can rest assured you're in compliance.
Peter Mavrikis is an author and editor with over 25 years of experience in publishing. He has worked as the Editorial Director for Barron’s Educational Series, as well as Kaplan Test Prep, where he ran the test prep, foreign language, and study guide divisions. Peter has also written several books on history, exploration, science, and technology.