Thanks and a hat tip to Dennis Smith for sending me this article written by  Peggy Creveling

Peggy Creveling, CFA, & Chad Creveling, CFA

This article is for general informational purposes only and is not intended as specific tax advice. Please consult your tax advisor for advice relevant to your situation.

With the additional tax filing forms and reporting requirements that the Foreign Account Tax Compliance Act (FATCA) has brought, merely filing their U.S. tax return may seem like achievement enough for Americans living overseas. Yet going beyond simply completing tax forms and instead spending some time figuring out how you can save on tax (both in the current year and over the long run) can have real financial benefits. After all, taxes can be one of the single biggest expenses for many American expats, and this extends to retirement. If done well, long-term tax planning can really pay off.

1. If you have a foreign spouse, choose your tax filing status carefully. Expat Americans with spouses who are neither U.S. citizens nor green card holders have a choice of U.S. tax filing status. The options include either married filing jointly (MFJ), married filing separately (MFS), or head of household (HOH) if you have children. Many expat Americans in this situation don’t spend much time deciding which filing status is best for them. Yet the U.S. tax filing status you choose may make a big difference on how much U.S. tax you pay, both in the current year and over the long run. Each filing choice has pro and cons, and the best option depends on your specific situation. Therefore, it’s important to carefully weigh your options. See “American Expats with Foreign Spouses: Choosing Your U.S. Tax Filing Status” for more information on this issue.
2. File the correct forms. Most of us have heard of Form 2555 (Foreign Earned Income), Form 1116 (Foreign Tax Credit) and even the new Form 8938 (Statement of Foreign Financial Assets). But what about Forms 926, 3520, 5471, or 8865? There are a number of rather obscure tax forms that may be specific to Americans who live abroad. If you file your taxes yourself or have the help of a hometown CPA who is not that familiar with expat returns, you may not be aware of all the requirements. To avoid needless and expensive penalties, check this list of U.S. tax forms for expat Americans.
3. Avoid investing in foreign mutual funds or PFICs (unless in doing so you reduce your overall tax burden). Many Americans are still unaware of the IRS’s particularly harsh tax treatment of foreign-incorporated investments, such as overseas mutual funds and pension plans. Unless the fund is structured as a partnership, the IRS will generally classify it as a passive foreign investment company (PFIC). This includes pretty much any overseas mutual fund, pension plan, money market fund, or insurance-wrapped investment scheme.

   If you’re not sure if something is a PFIC, check with a U.S. tax advisor before investing. Because the tax on PFIC earnings is typically much higher than what would be due on a U.S.-based mutual fund, it’s often best for Americans to avoid PFICs and instead hold their investments in a U.S. custodian that’s friendly to expats.

   Of course, there are some exceptions, such as if you invest in a PFIC that shields your income from enough local tax to offset any additional tax you might face in the U.S. For example, due to their local tax deduction, investing in PFICs such as Thailand’s Retirement Mutual Funds (RMFs) or Long-Term Equity Funds (LTFs) can make sense for American expats who pay Thai income tax. Another exception might be if a local money market fund provides a currency hedge. Unless there’s a specific reason to purchase a PFIC, however, the tax consequences usually make these poor investment choices for American expats.

4. If you do invest in PFICs, choose the mark-to-market option when filing Form 8621. PFIC investment earnings are reportable to the U.S. on Form 8621. Using the form, those Americans who have invested in a PFIC (such as a Thai RMF/LTF or another foreign fund) have a choice of how to calculate the U.S. tax due on the earnings. Unless the PFIC was originally structured so that its income and distributions allow for treatment as a qualifying electing fund (QEF), the U.S. expat taxpayer will usually only have two choices of the tax treatment of the PFIC, either 1) excess distribution or 2) mark-to-market.

   At first, the excess distribution method might seem the better choice, because you only need to file Form 8621 when a distribution (such as a dividend) or a sale of shares takes place. This is misleading, however. The tax calculation on the sale or distribution income uses a compound income tax at the highest possible individual ordinary rates during the holding period (not the taxpayers’ actual marginal rate) plus a non-deductible interest charge compounded over the period of deferral. This makes choosing the (usually default) excess distribution method prohibitively expensive.

   Instead, mark-to-market treatment will almost always result in a lower tax bill over the investment period. Using mark-to-market, a U.S. investor may elect to include each year as taxable ordinary income at his U.S. marginal rate, an amount equal to the excess of the fair market value of the PFIC stock over the adjusted basis of the PFIC stock. (Losses can be deducted as ordinary losses.) Although this does mean filing Form 8621 each year for every PFIC, the mark-to-market method will generally be much easier to manage and less expensive tax-wise. This is a technical question, however, so anyone holding a PFIC is urged to consult with a U.S. tax advisor experienced in expat issues.

5. Where permitted, consider contributing to U.S. tax-advantaged accounts. There are many types of U.S. tax-advantaged accounts. If you qualify to invest in one or more of them, they can result in sizeable tax savings over the long run. Some, such as traditional IRAs, 401(k)s, or SEP IRAs, allow you to defer taxable income and potentially lower your marginal tax rates in the current year. Others, such as Roth IRAs, Roth 401(k)s, and 529 plans, offer no tax deferral but investment earnings are never taxable at the federal or state level, making them a bit like perfectly legal offshore accounts. It can pay to carefully research to see whether you qualify for these types of accounts and whether investing in them will save you in tax over the long run. There are many potential trip-ups, however. For example, you may still have to pay tax on investment earnings in your country of residence. If that’s the case, these accounts may not save you overall tax.
6. Only contribute to an IRA or Roth IRA if you qualify. You can only contribute to a traditional IRA or Roth IRA if you have unexcluded earned (salary) income. This is the case even if you do not take a tax deduction for the contribution. Expats who use the foreign earned income exclusion and earn less than the exclusion amount ($97,500 in 2013) are not permitted to make an IRA contribution. If audited, they face a 6% penalty per year on the amount that is not permitted until it’s corrected or removed from the account.

   To avoid a penalty, if you earn less than the foreign earned income exclusion, consider changing your method of calculating tax due to use the foreign tax credit instead of taking the exclusion. That way, you will have unexcluded earned income and may qualify to make a contribution. If switching to the foreign tax credit isn’t tax-efficient for you, there’s no reason you couldn’t simply invest the same amount you would have contributed in a taxable account instead. If you’re careful, you can still manage the taxable account to be tax-efficient and to defer capital gains. For more information, see “American Expats and IRAs: A How-To Guide.”

7. Avoid making deductible contributions to U.S. tax plans with income on which you’ve already paid foreign tax. Expats commonly make this error, which can result in tax inefficiency and a higher U.S. tax bill over the long run. It involves expats who have unexcluded earned income that is taxed locally and who make U.S.-deductible contributions to plans such as IRAs or SEP IRAs. While they may lower their U.S. tax bill by a certain amount in the current year, the current year savings is often not enough to come out ahead over the long run.

   For example, consider an American expat in Thailand earning above the foreign earned income exclusion who contributes the equivalent of $30,000 to a SEP IRA. Although the entire amount may be deductible on their U.S. income tax, the net savings in U.S. tax may not be that great, as a large portion of the U.S. tax on this amount would have already been offset by Thai foreign tax credits.

   Another way to look at it: If a U.S. expat’s overall tax burden (U.S. plus Thai) were reduced by $3,000 on the $30,000 SEP IRA contribution, on the plus side he would have benefited by an overall tax savings of 10% of the amount contributed. However, he would also have made the entire $30,000 contribution pretax, meaning that one day all earnings (dividends, interest, and capital gains) would be taxed at a future U.S. rate that is almost certain to be much higher than 10%. In this case, the 10% upfront savings would not be worth it, and the expat would have been better off foregoing the deduction, putting the savings in a regular brokerage account, and managing it to maximize tax deferral on capital gains while enjoying overall lower tax rates and tax payable over the long run.

8. File every year, even if you do not think you owe U.S. income tax. If you are a U.S. citizen, permanent resident, or hold a U.S. passport as a secondary nationality, your worldwide income is subject to U.S. income tax regardless of where you live. Unless your income is below the filing limit ($9,750 for single filers in 2012), you are required to file U.S. income taxes every year, even if your earnings are very low and you do not owe any U.S. income tax.

   Filing your taxes is important. If you meet certain requirements and you file your own return outside of an audit, you may be able to exclude foreign earned income (salary income) from your U.S. taxes (for 2013, this will be $97,600). But the right to take the foreign earned income exclusion and other deductions (such as for housing costs) is voluntary and is only allowed if you file your return. If you’re audited for not filing, the IRS may disallow the exclusion and in that case you may owe tax and penalties where otherwise you would not.

Investing Time in Tax Planning Now Can Pay Off Later

As shown in the tips above, American expats who spend some time figuring out ways they can save on U.S. tax—especially over the long run—will receive benefits that compound over time. If done well, long-term tax planning can really pay off for Americans abroad.

Additional Resources

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About Creveling & Creveling Private Wealth Advisory

Creveling & Creveling is a private wealth advisory firm specializing in helping expatriates living in Thailand and throughout Southeast Asia build and preserve their wealth. Through a unique, integrated consulting approach, Creveling & Creveling is dedicated to helping clients cut through the financial intricacies of expat life, make better decisions with their money, and take the steps necessary to provide a more secure future. For more information visit www.crevelingandcreveling.com.