As more and more Americans consider retiring abroad, it’s important to understand the tax implications of living in a foreign country after leaving the workforce. Whether you’re moving to take advantage of a lower cost of living, a warmer climate, or a different cultural experience, retiring abroad can have significant tax consequences. The US tax system is unique in that it taxes its citizens on their worldwide income, no matter where they reside. This article outlines the key tax considerations for US citizens who plan to retire overseas.

US Tax Obligations While Living Abroad

The United States has a citizenship-based taxation system, meaning US citizens and resident aliens must report their worldwide income to the IRS, regardless of where they live. This includes income from pensions, Social Security, retirement accounts (like IRAs and 401(k)s), rental income, dividends, and even capital gains from the sale of foreign property. Here are the primary aspects to consider:

Filing Requirements

If you are a US citizen or resident alien, you must file an annual tax return with the IRS if your income exceeds certain thresholds. You may also be required to file other forms depending on your financial situation, such as:

  • Form 2555 (Foreign Earned Income Exclusion) to exclude a portion of your earned income from US taxation if you meet certain requirements.
  • Form 1116 (Foreign Tax Credit) to claim a credit for foreign taxes paid on foreign-sourced income, which can help reduce the risk of double taxation.
  • FBAR (FinCEN Form 114) to report foreign bank accounts if the total balance of your foreign accounts exceeds $10,000 at any time during the year.

Foreign Earned Income Exclusion (FEIE)

If you are earning income while living abroad, you may qualify for the Foreign Earned Income Exclusion (FEIE), which allows you to exclude up to a certain amount of your earned income from US taxation. For 2023, the FEIE limit is $120,000 per person, and this amount is adjusted for inflation each year. To qualify for the FEIE, you must meet certain residency or physical presence tests:

  • Bona Fide Residence Test: You must be a resident of a foreign country for an uninterrupted period that includes an entire tax year.
  • Physical Presence Test: You must be physically present in a foreign country for at least 330 full days during any 12-month period.

It’s important to note that the FEIE only applies to “earned income” (such as wages and salary), not passive income (such as dividends, interest, or pension distributions).

Foreign Tax Credit (FTC)

If the country where you retire abroad taxes your income, you may be eligible for a Foreign Tax Credit (FTC). This credit allows you to reduce your US tax liability by the amount of taxes you pay to a foreign government, which helps to prevent double taxation. To claim the credit, you’ll need to file Form 1116 and provide documentation of the foreign taxes you paid.

However, the FTC does not apply to income excluded by the FEIE. This means that if you exclude foreign earned income using the FEIE, you cannot use the FTC to offset taxes on that income. But if you have other income that is taxable in both the US and your host country, the FTC can be an important tool for reducing your overall tax burden.

Taxation of Pensions and Retirement Accounts

The taxation of retirement income is another key consideration for US citizens retiring abroad. Here’s a breakdown of how various types of retirement income are taxed:

    • Social Security: Social Security benefits are subject to US taxation, though the level of taxation may vary depending on your country of residence and any tax treaties in place.
    • Pensions: US pensions, such as those from government or private sector employers, are subject to US tax, and foreign governments may also tax them. Depending on your host country’s tax laws and the existence of a tax treaty between the US and that country, your pension may be taxed only by the US or may be subject to taxes in both countries.
    • 401(k) and IRA Withdrawals: Distributions from US retirement accounts like 401(k)s and IRAs are taxed as ordinary income in the US. Many countries tax retirement account distributions as well, but if a tax treaty exists, the country where you reside may offer tax relief or exemption. It’s important to consult the treaty provisions to determine the tax treatment of your retirement accounts.

Tax Treaties and Totalization Agreements

The US has tax treaties with many countries to help mitigate double taxation. These treaties generally address which country has the right to tax certain types of income, such as pensions, interest, and dividends. Depending on the treaty, you may be able to reduce or eliminate taxes on certain income streams.

In addition to tax treaties, the US has Totalization Agreements with several countries. These agreements are designed to eliminate dual social security taxation and ensure that workers are only required to pay social security taxes to one country, either the US or the foreign country. These agreements also help ensure that workers accumulate social security credits in one country even if they have worked in both countries.

Health Care and Medicare

Medicare does not generally provide coverage outside the US. If you plan to live abroad permanently, you will need to explore alternative health insurance options in your country of residence. Some expatriates opt to continue paying into Medicare Part A for hospital insurance, while others may choose private insurance plans in their new country.

If you are a US citizen living abroad and are 65 or older, you are still eligible for Medicare, but you must ensure that you have supplementary health insurance to cover medical expenses outside the US.

Estate and Gift Taxes

US citizens, regardless of where they reside, are subject to US estate and gift taxes. This means that if you pass away with assets exceeding the estate tax exemption threshold (currently $12.92 million for 2023), your estate may be liable for US estate taxes. The tax laws also impose reporting requirements on foreign assets, including gifts and bequests received from foreign individuals or estates.

Some countries impose their own inheritance or estate taxes, so it’s important to understand both US and local tax laws when planning for your estate abroad.

Conclusion

Retiring abroad can be a fulfilling experience, but it comes with complex tax considerations. As a US citizen, you are required to report and pay taxes on your worldwide income, even if you live overseas. However, there are mechanisms like the Foreign Earned Income Exclusion and Foreign Tax Credit that can help reduce your tax liability. Additionally, understanding the tax treaties, retirement account rules, and estate planning considerations in both the US and your country of residence is crucial for a smooth transition to retirement abroad.

Before making any decisions, it’s recommended to consult with a tax professional experienced in expatriate taxation to ensure that you are compliant with both US and foreign tax laws and to optimize your tax situation.