Tax on Foreign Income: What You Need to Know Before Moving to the US

Considering a move to the United States involves more than just packing your bags; it also requires understanding how foreign income is taxed. The U.S. tax system is complex, particularly for those with earnings from abroad. Missteps in handling foreign income can lead to unexpected tax liabilities and penalties.

Understanding key aspects of taxation on foreign income helps ensure compliance and optimize financial outcomes. With this knowledge, individuals can make informed decisions about their finances when relocating to the U.S.

Residency Classification

Determining your residency status is essential to understanding how your foreign income will be taxed in the United States. The U.S. tax system classifies individuals as either residents or non-residents for tax purposes, which significantly impacts tax obligations. The Internal Revenue Service (IRS) uses two primary tests to determine residency: the Green Card Test and the Substantial Presence Test.

The Green Card Test is straightforward—if you have a Green Card, you are considered a U.S. resident for tax purposes, regardless of your physical presence in the country. The Substantial Presence Test requires calculating the number of days you are physically present in the U.S. over a three-year period. Specifically, you must be present for at least 31 days during the current year and 183 days over the three years, which includes all days in the current year, one-third of the days in the previous year, and one-sixth of the days in the year before that.

For those who do not meet these criteria, the IRS provides the Closer Connection Exception, allowing individuals to claim non-residency status by demonstrating stronger ties to another country, such as family or business interests. Residency status can change annually, so ongoing assessment is necessary.

Worldwide Reporting Obligations

The U.S. tax system operates on a worldwide income basis, requiring U.S. residents to report all income, regardless of its origin. This includes wages, dividends, interest, and other foreign earnings. U.S. tax residents must disclose their global income on Form 1040 to comply with federal tax laws.

Additional obligations exist under the Foreign Account Tax Compliance Act (FATCA), which mandates reporting specified foreign financial assets if they exceed certain thresholds. Single filers must report assets exceeding $50,000 on the last day of the tax year or $75,000 at any point during the year. For married couples filing jointly, the thresholds are $100,000 and $150,000, respectively. These disclosures are made via Form 8938, filed with the annual tax return.

The Report of Foreign Bank and Financial Accounts (FBAR) is another critical requirement. U.S. residents must file an FBAR if they have financial interests in, or signature authority over, foreign accounts exceeding $10,000 in aggregate value during the year. The FBAR is filed separately with the Financial Crimes Enforcement Network (FinCEN) using Form 114.

Foreign Earned Income Exclusion

The Foreign Earned Income Exclusion (FEIE) allows eligible taxpayers to exclude a portion of their foreign earnings from U.S. taxation. As of 2024, this exclusion is set at $120,000. To qualify, individuals must meet the bona fide residence test or the physical presence test.

The bona fide residence test requires establishing residency in a foreign country for an uninterrupted period that includes an entire tax year. This test considers factors such as the intention to stay indefinitely and the nature of employment. Alternatively, the physical presence test requires the taxpayer to be physically present in a foreign country for at least 330 full days during a 12-month period.

The FEIE can significantly reduce taxable income. For example, a taxpayer earning $150,000 abroad could exclude $120,000, leaving only $30,000 subject to U.S. taxation. Eligible taxpayers may also deduct or exclude certain housing costs associated with living abroad, which is particularly beneficial for those in high-cost locations.

Foreign Tax Credit

The Foreign Tax Credit (FTC) helps U.S. taxpayers mitigate double taxation on foreign-sourced income. While the U.S. taxes residents on worldwide income, the FTC allows them to claim a credit for taxes paid to foreign governments. This credit directly reduces U.S. tax liability dollar for dollar.

To qualify, the foreign tax must be an income tax or a tax in lieu of an income tax, and the taxpayer must have a legal obligation to pay it. The credit is calculated using Form 1116, which ensures it does not exceed the U.S. tax liability on foreign income.

Tax Treaties

Tax treaties simplify international taxation for individuals moving to the United States. These agreements, negotiated between the U.S. and other countries, aim to prevent double taxation and foster cross-border economic activity by establishing clear rules for taxing income across jurisdictions.

One key benefit is the allocation of taxing rights, which specifies which country has the primary right to tax certain income types, such as wages or pensions. Tax treaties often allow for exemptions or reduced tax rates. For instance, under the U.S.-U.K. tax treaty, certain pension distributions are taxed only in the country of residence. Taxpayers can claim these benefits by filing Form 8833 with their U.S. tax return.

Tax treaties also include provisions for resolving disputes through mutual agreement procedures (MAPs), which address inconsistent tax treatment between two countries. However, taxpayers must actively claim treaty benefits and ensure compliance with reporting requirements.

Penalties for Non-Compliance

Failing to meet U.S. tax obligations on foreign income can lead to severe financial and legal consequences. The IRS enforces penalties for unreported foreign income or undisclosed foreign accounts. These penalties may include fines, interest on unpaid taxes, and, in cases of willful violations, criminal charges.

For unreported foreign income, penalties may include fines of up to 20% of the underpayment amount for negligence or 75% for fraud. Failure to file Form 8938 under FATCA can result in a $10,000 penalty, with additional fines of up to $50,000 for continued non-compliance. The IRS may also extend the statute of limitations on audits for unreported foreign income.

Failure to comply with FBAR requirements carries even steeper penalties. Non-willful violations can result in a penalty of $10,000 per violation, while willful violations may incur penalties equal to the greater of $100,000 or 50% of the account balance. Criminal charges are possible in extreme cases. These consequences underscore the importance of accurate reporting and seeking professional guidance to navigate U.S. tax requirements.