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Understanding Your Tax Liability as a Digital Nomad

When COVID-19 first reared its ugly head in early 2020, most assumed working from home would be a temporary thing. Many employers, however, have given their employees the option of continuing to work remotely even after offices reopened. In some cases, employees have the flexibility of working from anywhere they desire, including locations outside of the United States. Thanks to multiple remote work programs, many Americans have taken up temporary residence in countries like Iceland, Dubai, and the Bahamas. Before you become a digital nomad, however, it’s important that you understand your tax liabilities at home and abroad.

Am I Required to Pay Taxes To The Country Where I Stay?

Many countries offering digital nomad visas do not tax income that is earned outside of their country. Bali, for example, allows you to stay for up to five (5) years without paying income taxes. Dubai and Costa Rica are also income tax exempt. It’s best to research any destination on your list before making a final decision. Not only do you have to consider tax implications, but also application requirements and fees. The amount of time you’re allowed to stay also varies when traveling on a digital nomad visa. If you decide to travel to a country without a nomad program, the general rule of thumb is to stay less than six months to avoid potential tax implications or double taxation.

Will I Have to Pay U.S. Income Taxes?

Unfortunately, living abroad while working remotely does not get you off the hook for paying taxes here in the states. The U.S. is one of the few countries that taxes its citizens regardless of where they are physically located. That means you’ll still be responsible for federal income taxes, and possibly local and states taxes, too. Be sure to check with your state’s tax authority to determine which taxes you’ll be required to pay while away.

When it comes time to file your federal taxes, however, you may be able to reduce or eliminate any taxes owed by either claiming the foreign tax credit or taking the foreign earned income exclusion, if eligible.

Foreign Tax Credit

If you pay foreign taxes to another country and are subject to U.S. tax on the same income, you may be able to take either a credit or itemized deduction for those taxes. In most cases taking the credit, which reduces your U.S. tax liability, is the better option. Generally, the following must be met to qualify for the foreign tax credit:

  • The tax must be imposed upon you
  • You must have paid or accrued the tax
  • The tax must be the legal and actual foreign tax liability
  • The tax must be an income tax (or a tax in place of an income tax)

You’ll need to file Form 1116, Foreign Tax Credit to claim the credit.

Foreign Earned Income Exclusion

To reduce your U.S. federal income tax bill by using the foreign earned income exclusion, you’ll need to spend at least 330 days or more outside of the U.S. in a 365-day period. This is known as the physical presence test. If you have a digital nomad visa, on the other hand, it will generally suffice as evidence that you are a permanent resident in another country. This will allow you to take the foreign earned income exclusion under the bona fide residence test.

You must file IRS Form 2555, Foreign Earned Income, with your Form 1040 to claim the exclusion. For 2021, you may exclude up to $108,700 of your earned income. In addition to the foreign earned income exclusion, you may also be eligible to claim an exclusion or deduction from your gross income for reasonable housing expenses (foreign housing exclusion or deduction).

Do I Still Pay Social Security Taxes as a Digital Nomad?

Yes. If you work for a U.S. company or are self-employed, you’re required to pay Social Security taxes. There are some ways to reduce your responsibility, but it typically involves setting up a corporation abroad or using Totalization Agreements. It’s also important to keep in mind that not paying into Social Security may affect your future benefits.

Seek Advice From a Tax Professional

If you’re thinking about becoming a digital nomad, it’s best to consult with a tax professional before making any plans. They can help you identify ways to lower your tax liability and determine which tax forms you’ll need to file, such as the Foreign Bank and Financial Accounts (FBAR) report or Form 8938, Statement of Specified Foreign Financial Assets. Just be sure to do your research before heading off to new destinations.