You need to know about the Foreign Tax Credit for digital nomads if you are a US taxpayer. As a US citizen or resident, you will keep on paying taxes to the Internal Revenue Service (IRS) even after you leave the country. To soften the blow, the legislation provides for certain exemptions and deductions. The Foreign Tax Credit (FTC) is one of those.
What is the Foreign Tax Credit for digital nomads?
The FTC enables you to credit taxes you paid abroad against US taxes. This basically you means you save one dollar in US taxes for every dollar in taxes you paid abroad. Therefore, you need to distinguish a tax credit from a tax deduction. With a tax deduction, you only lower your taxable income. An example will make this more clear.
Let’s say you make $10.000 and a (fictious) US tax rate of 10% would apply to this income. We assume you already paid $500 in taxes abroad. Your US tax liability would in principle amount to $1.000 (10% of $10.000). By applying the FTC, your US tax liability will only be $500 as you can credit the $500 you already paid abroad from your US tax liability. If you would have a tax deduction of $500 instead of a tax credit, the outcome would be different. In that case, your taxable income is lowered from $10.000 to $9.500. Consequently, US your tax liability would still amount to $950 (10% of $9.500).
You should note that the actual calculation of the FTC gets more complicated than this. The reason is that you need to take into account your worldwide income. Based on this some limits apply.
When to apply the Foreign Tax Credit for digital nomads?
The FTC will mainly come in handy if your taxes abroad are rather high. In that case, you could eliminate your US taxes altogether. You can also carry forward any excess credits for up to ten years. So, even if you would return to the US in a later stage of your life, you could still benefit from the FTC you claim today. Another option is to carry it back to the previous tax year.
As mentioned, you need to pay taxes to a foreign country to qualify for the FTC. Not just any tax can be taken into account for the FTC. You need to take into account some conditions that apply. First of all, the foreign tax needs to be an income tax. In addition, the tax needs to be mandatory. Any voluntary contribution to the government doesn’t qualify. Furthermore, you need to actually pay or owe the tax.
Other attention points
Unlike the Foreign Earned Income Exclusion (FEIE), the FTC also applies to passive income. The FEIE is limited to earned income (e.g. wage or professional income). The FTC applies to all income and doesn’t have this limitation. Furthermore, the FEIE rather works like a tax deduction and not like a tax credit. In any case, you can only apply one of both. Which one is best in your case will depend on your personal situation.
You can also have a look at the website of the IRS to find more information about the FTC.
Foreign Tax Credit for digital nomads: conclusion
The Foreign Tax Credit for digital nomads is a way to limit your US tax liability. Whether or not you should try to profit from this or other tax benefits depends entirely on your personal situation.