Thinking of taking a year off?
We have had a number of inquiries recently from clients considering taking a year off from working overseas to travel, catch up with family, pursue graduate education, or just take a break. Here are some factors to keep in mind regarding how this might affect your tax situation.
Foreign Earned Income Exclusion
If you have been taking the Foreign Earned Income Exclusion (FEIE) in previous years and stop working overseas mid-year, here’s how that works:
- You can still claim the FEIE against the foreign income you earn up until your employment ends.
- The maximum FEIE you can claim will be pro-rated according to how many days you were still employed overseas during the year. For example, if you stop work on June 30, you’ll be allowed approximately half (181/365) of the maximum exclusion.
- If you remain overseas to travel but are no longer employed, the FEIE will normally be pro-rated according to how long you were actually still working abroad.
Foreign Tax Credit
Your eligibility to claim the Foreign Tax Credit is not affected by whether you are still working or living overseas. If you are required to pay foreign income tax on foreign-source income that is not excluded under the FEIE, you can take a credit against your US taxes, regardless of whether you are still living overseas. (The source of your income is determined by where you perform the actual work, not by the location of the employer.)
Working during the gap year
- If you work in the US during your gap year, that income will be taxed as normal US income. Note that even if your foreign income from part of the year is excluded, it causes your other income to be taxed at higher rates than if the gap-period income were your only income. You may therefore find yourself owing more income tax than you expected.
- The Foreign Tax Credit can only be applied against US tax on foreign-source income. You cannot use the Foreign Tax Credit to offset US tax on US-source income.
- If you do freelance, consulting, or other non-employee work, that income will be subject to self-employment tax (Social Security and Medicare taxes–roughly 15% of net self-employment income), regardless of whether you are in the US or overseas.
- If you work in the US during your gap year, you will probably be subject to state income tax.
State residency issues
If you work in the US, you may find that you’ve (purposely or not) established residency in the state where you’re working. If you later move back overseas, you may need to continue filing state tax returns, and possibly paying state taxes, after your departure–depending on the rules of the particular state. Beware of Massachusetts in particular, which does not honor the Foreign Earned Income Exclusion and is diligent about asserting its right to tax former residents. California also does not honor the Foreign Earned Income Exclusion, but will treat you as a nonresident for tax purposes if you move overseas with an employment contract for a sufficient period of time. There may be a few other states to watch out for as well. The State Residency Issues page can help you check the residency rules for a number of states.
Returning to work overseas
If you decide to head back to work overseas after taking some time off, you will need to start from scratch if you want to qualify for the FEIE again. Review the First Year Overseas page for a refresher on how to qualify again for the FEIE. Of course, as always, if you are subject to foreign income taxes, you may choose to claim the Foreign Tax Credit rather than (or sometimes in addition to) the exclusion.