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MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 4:39 pm
by quantumleap
Link to original thread: Foreign Earned Exclusion: New Law Bad News
Appears that the new provisions that apply to foreign earned income exclusion have not been covered on this forum yet, except in the thread below: Converting IRA to Roth during RNOR So am taking the liberty of starting a new thread on this subject. It contains bad news - hopefully the messenger wont be shot 
The silver lining (count blessings, especially in bad times) is that what follows is about US taxation and not Indian taxation - so non-residents of India and RbutNORs under Indian tax law need not be unduly worried that the GOI tax exemption in respect of non-Indian source income that they currently enjoy has been taken away. What follows would be of interest to current (and prospective) USCs residing outside US, and others who are required to or opt to file as US residents (for US tax purposes) when residing outside US. The new tax law signed in May 2006 by President Bush applies from Jan 1, 2006 i.e. for tax year 2006 and beyond, and brings in a stacking provision in so far as foreign earned income exclusion is concerned, which is perhaps best explained via an example: Say a USC has foreign (for work done outside US) earned (salary, wages, compensation, tips) income of $40K (which is excluded from gross income under the foreign earned income provision) and other income (investment income - rent, interest, dividends, ...) from $30K (included in gross income). For simplicity, assume that the other income is ordinary income and does not contain long term capital gains. Prior to the new tax law, one paid tax only on the $30K at graduated tax rates (after availing standard deduction, personal exemptions), starting at the lowest tax slab. So, for the $40K excluded one effectively got tax relief at one's marginal tax rate and higher. Now, under the new law, one needs to do the following: (i) Determine tax first on $70K at graduated tax rates (after availing standard deduction, personal exemptions), starting at the lowest tax slab. (ii) Then one needs to determine tax on $40K (the excluded portion alone) at graduated tax rates (after availing standard deduction, personal exemptions), starting at the lowest tax slab. Tax liability is (i) - (ii). So in effect, now one gets tax relief for the excluded income (foreign earned income) only at the lowest tax rates (including the "0% slab" in which one avails standard deduction etc) i.e. the $30K of income that is included gets taxed at rates that would apply had the foreign earned income exclusion not existed at all. -------------------- Text of Relevant Portion of New Law (for those who have a taste for legalese) Determination of Tax Liability on Nonexcluded Amounts- For purposes of this chapter, if any amount is excluded from the gross income of a taxpayer under subsection (a) for any taxable year, then, notwithstanding section 1 or 55--
(1) the tax imposed by section 1 on the taxpayer for such taxable year shall be equal to the excess (if any) of--
(A) the tax which would be imposed by section 1 for the taxable year if the taxpayer's taxable income were increased by the amount excluded under subsection (a) for the taxable year, over
(B) the tax which would be imposed by section 1 for the taxable year if the taxpayer's taxable income were equal to the amount excluded under subsection (a) for the taxable year, ....
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:12 pm
by quantumleap
Bobus, you better watch your back now, you could be shot :-)
Just for the record, for those who R2I for retirement, this new rule makes no change in their tax liability. So take your USC if that was your initial plan.
This new rule is bad news indeed for those who wish to R2I and work at high paying jobs and who also hold investments that return high dividends and income. One way of mitigating your tax liability is by keeping a bunch of your money in tax deferred (IRA, 401K, etc) plans & investing in index funds (or funds that have low turn over ratios) in a taxable account. For cash/bonds part, I Bonds look like a good place now (tax deferred) if you exhaust IRA.
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:12 pm
by quantumleap
I believe a tax payer who has earned income abroad and files as US resident can choose (at her option) between the following:
(a) Foreign earned income exclusion
(b) Foreign tax credit (double taxation relief for tax paid to the country which is the source of the earned income) under IRC (no need to appeal to any tax treaty, so USCs are eligible too) after including foreign earned income in gross income.
Depending on specifics of the case, especially since rules for (a) have now changed, and given high rates of India tax on Indian earned income, choosing (b) may result in a lower overall (both countries combined) tax liability than under (a).
Potential Good News: Further, again depending on specifics of the case, the tax liability to IRS may well be zilch under (b), even if it is not so under (a), thus leaving the tax payer in the same position that she was prior to the new law signed in May 2006.
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:13 pm
by quantumleap
Bobus/Mel,
This change affects USC/green card holders only, correct?
Thanks,
Rags.
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:13 pm
by quantumleap
#4, yes not applicable to NRAs.
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:14 pm
by quantumleap
This change affects USC/green card holders only, correct?
Applies to anyone filing as US resident for tax purposes. What does the following extract in blue (with new emphasis) from #1 convey?
GC holders and USC are required to file as US residents whereever they may reside. In addition, others may opt to or be required to file as US residents, because they are married to someone who file as US resident or because in the year of departure from US they meet the substantial presence test.
What follows would be of interest to current (and prospective) USCs residing outside US, and others who are required to or opt to file as US residents (for US tax purposes) when residing outside US.
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:14 pm
by quantumleap
I have $110,000 in my 401K. We are planing to R2I in Jan 2008. We will qualify for 2 yr RNOR. Me and my wife have lived in the USA for 11 yrs. We have 2 kids. I was planning to roll over the money to IRA and withdraw during 2 yrs of RNOR period as per RRK limits. I was hoping to minimize taxes by doing this. We both will have earned income in India upon R2I.
This new regulation adds a twist to my planning. I really do not understand how this will affect my above mentioned strategy.Can some one explain?
Looser
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:15 pm
by quantumleap
Even we were planning to withdraw during the RNOR period after jan 2008. But if one stayed in US for more than 7 years and were to leave in january then one would have 1 year of NRI and 2 years of RNOR which gives a person 3 years to pull out the roll over IRA investments?Is my understanding correct?
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:15 pm
by quantumleap
#7 and #8:
With the info you have provided, it is difficult to say anything beyond what has already been posted in prior posts about how the new tax law impacts you.
(a) What will your and your spouse's status be at R2I - USC, GC or H1?
(b) Even without the new tax law, why the tearing hurry to complete withdrawal from IRA by end of RNOR period?
(c) What will your and your spouse's earned (salary) income in India be per year after R2I?
(d) Apart from IRA withdrawals and (c) above, what will your and your spouse's investment income (rent, interestn, dividends, cap gains) from all sources (US and Indian) be after R2I on a calendar year basis?
MT: US laws on Foreign Earned Income Exclusion
Posted: Fri Jan 26, 2007 5:16 pm
by quantumleap
Hi Bobus,
We are planning to R2I around jan 2008. By then, we are expecting to have maybe around 220k as part of our IRA assets. Both of us are working in the US and are planning to find jobs when we move to India. My spouse be a USC and I would be GC and be applying for a re-entry permit when we R2I. We would be filing as MFJ+1 kid .We are not cure if we want to deal with all the hassles of pulling out the money after the RNOR period. Do you think there would be substantial tax savings if we were to pull out during ROR period.