As an expat living abroad, you are responsible for paying taxes in both your country of residence, and if you are a citizen of a worldwide taxing country like the US, you are also responsible for home country taxes. Tax equalization is the process of your employer helping with preparation and payment of your taxes to make it as if you were living at home. Without a benefit like tax equalization, the cost of being an expat would be too high for you and would likely scare you away from the opportunity.
Why Tax Equalization?
Because you are responsible for taxes in 2 countries while on assignment, you have an extraordinarily high tax liability placed upon you. The extra tax levied, not to mention extra hassle of paying taxes in 2 countries concurrently will scare many potential expats away from the opportunity of living and working abroad. In order to sweeten up the deal for potential expats, many companies implement tax equalization as a component of the total expat package.
Tax equalization makes it simpler for the assignee to understand what they have to and don’t have to pay taxes on. Your tax liability becomes the same as if you were living back home and your employer takes care of the remaining balance.
What is Included in Tax Equalization?
While on an expat assignment you have various income and costs that fall into 2 categories, taxable and non-taxable in terms of your hypothetical tax liability.
Taxable Income From Your Employer
- Base Salary
- Merit Increases
- Overtime Pay
- Stock Option Income
- Flexible Benefits
- Vacation Bonus, Pre-Tax Benefit Deductions, 401k, etc.
- Other Miscellaneous Pay from the Company
Taxable Personal Income
- Interest, Dividends, Royalties
- Capital Gains and Losses
- Net Rental Income and Losses
- Personal Business Income
- Retirement Income
- Spouse’s Earned Income
Non-taxable Foreign Assignment Income
- Goods & Services Differential
- Housing and Utilities Allowance
- Location Premium (Hazard Pay)
- Driver / Vehicle Allowance
- Spousal Assistance
- Hardship Allowances
- Relocation Allowances and Reimbursements
- Family Language Instruction
- Property Management Fees
- Payments of Home and Host Country Taxes
Calculating Hypothetical Income Tax
Calculating your hypothetical tax is very easy. You just use the standard 1040 form along with supporting forms that you would while living in the US. All the of the other forms that will be included in your actual foreign assignment tax return are not needed for calculation of your hypothetical tax liability.
The industry term is a hypothetical tax, however, this amount is your personal tax liability while on assignment. The company pays the remainder of your taxes for both foreign and domestic countries.
You should apply all of the concepts for slashing your taxes with hypothetical taxes as well.
Calculating your hypothetical tax liability is as below:
- INCOME: All standard income
- LESS: “as if” deductions as if you were living at home
- LESS: Personal Exemptions and Standard Deduction
- EQUALS: Hypothetical Taxable Income
Deductions During Tax Equalization
You should be getting the idea now. With tax equalization, all of your tax liability calculations are based upon your home country tax code as if you were living at home making only the money you would have been making at home.
One concern while living abroad is the fact that your income becomes super inflated. Because your employer attributes all of its benefit costs to you as income on your W-2, your income may double or even triple. The inflated income will likely bring you above the contribution limit for deductible Traditional IRA and Roth IRA contributions. However, because you are being treated as if you make only the income of your base salary you may be able to deduct your contributions to a Traditional IRA from your taxes.
Pro Hack: You may be able to make deductible contributions to your Traditional IRA, that were actually non-deductible and then be able to roll them over to a Roth IRA. Through this maneuver, you are able to get pre-tax contributions into a Roth and never have to pay tax on it.
You also get the normal itemized deductions or standard deduction along with the personal deductions allowed on the 1040.
State and Local Income Tax
State and local taxes are treated the same way as the federal tax for tax equalization. One possible change from the standard living at home assumption is if you change your state of residency. There are many reasons to keep and/or change your residency. The biggest reason to change your state residency is to “move” to a state that has no income tax. This would allow you to save additional money every month while on assignment totaling upwards of $1,000 per year. It is confusing to all of us expats, why we have to pay state tax when we were did not live in the state for even one day during the year. You may also “move” states to establish residency in one to get in-state tuition for college.
Social Security and Medicare taxes are still yours to pay. Throughout the year social security and Medicare will be deducted from your paycheck, but will likely be above your hypothetical amount due to withholding of it from income in non-taxable income categories. Any extra amounts due will be taken care of by your employer.
If your spouse manages to make some money while on assignment, your empoyer will also do tax equalization on that amount. So if you make money while on assignment outside of work, your employer will be responsible for paying the local tax on it. This is a huge benefit for starting a side hustle and making it simpler to get off the ground.
After calculation of your hypothetical tax liability, your tax liability is known. However, that is only the beginning of the story. While on assignment you will be supplied with a professional tax preparer to prepare all of your taxes both locally and internationally. Because your employer is paying part of your taxes for you this is really a requirement. They prepare all the forms and send them to us for signatures and approval. It makes your tax preparation time very easy and stress-free.
From our perspective as expats, our employer is the IRS. We pay our taxes to our employer and then our employer distributes the true tax liability for us to the correct governments.
Foreign Earned Income Exclusion
All expats have heard about the foreign earned income exclusion, which allows you to exclude $102,100 from your taxes for 2017. This would allow me to exclude my entire salary if the company did not attribute all the extra costs to me and I would have a US tax liability of $0. However, because I am also responsible for taxes in China, my total tax liability would be more than paying the US tax alone. Your employer uses the foreign earned income exclusion to help offset their total tax liability.
It is unfortunate we do not get it for ourselves, but in the end, we pay fewer taxes than we would have with an equivalent salary in the US.
Tax equalization is the way of the future for enticing people into expat assignments around the world. It allows us to move the world over and not worry about the tax implications because we are secure in the knowledge that all is taken care of. Tax equalization can be an integral part in your pursuit of the dream of early retirement when coupled with the expat assignment.
Are you an expat with tax benefits? Are they the same or different?
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