Most Americans agree that the US tax code is too complicated. It can be even more impenetrable for taxpayers who are new to the country, says Abby Eisenkraft, CEO of Choice Tax Solutions, Inc.
Six tax matters that often trip up people from abroad when they file their first US returns…
Status matters—tax residency status, that is. If you’re a “resident alien” in the US, you’re required to report all of your income to the IRS—including money earned outside the US.
If you’re a “non-resident alien,” only your US-derived income—officially your “Effectively Connected Income” (ECI)—typically must be reported.
But the big question is, are you a resident alien or non-resident alien? That’s where things can get confusing, because your tax residency status may be different from your immigrant visa status. It’s not uncommon for people who are in the US part-time over multiple years to unknowingly become resident aliens. Best: If you spent 31 days or more in the US during the current tax year, it’s worth looking up the IRS’ “substantial presence test” on IRS.gov to determine your status.
Your “tax-free” foreign pension or investment account might be taxable in the US. Canadians who reside in the US often fail to report income earned by their “Tax Free Savings Accounts” (TFSAs). They understandably assume that these accounts are tax-free, as the name suggests. But: While the Canada Revenue Agency considers these accounts tax-free, the US Internal Revenue Service (IRS) does not. In fact, many types of foreign pensions and accounts that are tax-free in the owners’ home countries are taxable in the US…yet many others are not. Don’t expect clear-cut, commonsense patterns about which are taxable—it usually boils down to whether there’s a tax treaty in place between the two governments that deems this particular sort of account tax-free. Safest way to determine whether a specific “tax-free” foreign account is tax-free in the US: Consult with a tax preparer who has extensive experience working with foreign taxpayers.
Paying taxes in two countries usually doesn’t mean paying twice the taxes. If you pay income taxes in a foreign country as well as in the US, you likely will qualify for a tax credit that will offset the foreign taxes you’ve paid.
You might have to pay Social Security and Medicare taxes…even though you might never benefit from these programs. If you’re a resident alien for tax purposes, expect to pay hefty US Federal Insurance Contributions Act (FICA) taxes on your US earned income. Nonresident aliens sometimes must pay these, too, though there are exceptions. FICA taxes fund the US Social Security and Medicare programs. Trouble is, unlike US citizens, many aliens never get anything back from these programs, although certain countries have their own version of Social Security that may be recognized by our Social Security. To qualify for Social Security retirement benefits, it’s typically necessary to work in the US and pay FICA taxes for a minimum of 40 quarters—and many aliens don’t work in the US for that full decade. Certain Medicare benefits require a comparable duration of US employment, and Medicare typically covers only health-care services provided in the US, so it’s likely to be of little use if you leave the US when you retire even if you do qualify.
If you owe taxes to the US, you probably also owe taxes to a specific state. Most US states impose income taxes of their own…and that surprises people who are used to paying only national income taxes in their home countries. In fact, you might have to file returns in multiple states if you move from state to state and/or live in one state but work in another. Example: It’s not uncommon for people who work in New York City to live in New Jersey.
Failing to report foreign financial accounts can lead to massive penalties. If you’re considered a resident alien in the US for tax purposes, then your tax return probably isn’t the only financial form you need to file. You’re likely also required to submit a listing of your foreign financial accounts to the US Treasury Department on FinCEN Form 114—“FBAR,” for short. It’s easy to go wrong with the FBAR. Some people see that the threshold for reporting accounts is $10,000 and don’t report accounts that have balances below this figure—but that $10,000 threshold is an aggregate, meaning that all applicable accounts must be reported if the total amount in them adds up to more than $10,000 at any point during the tax year.
Reminder: It’s easy to make mistakes when it comes to converting the value of foreign accounts into US dollars. The exchange rate that matters is the one that applied at the end of the tax year, not the exchange rate on the day this form is filled out. And as noted above, some people fail to fill out FBAR forms because they don’t realize that the IRS considers them resident aliens.
