Do American Expatriates Still Owe State Taxes?

In the United States, each state has its own tax system, and for expats, understanding these rules can significantly impact their financial situation. Here's a breakdown of some key points to consider.

Firstly, it's important to note that passive income, such as stocks, forex trading, capital gains, rental income, and social security benefits, is not excluded from federal income tax. Each state will also tax income that is received within its borders, including rental income on properties located within the state.

For US citizens residing abroad, the worldwide tax system of the United States means that they are tax residents by default. To avoid state taxes, you'll need to eliminate ties to your original 'sticky state' by selling your home, moving your immediate family, closing bank accounts, cancelling voter registration, driver's license, and so on.

The Foreign Earned Income Exclusion (FEIE) allows qualifying individuals to exclude the first US$126,500 for tax year 2024. To be eligible for FEIE, you must meet specific criteria to demonstrate you have a tax home in another country. Passing the Physical Presence Test is the easier way to qualify for the FEIE and involves being in a foreign country or countries for 330 out of any 365-day period.

Under Safe Harbor rules, an individual who is domiciled in California but spends an uninterrupted period of 546 days outside the state for an employment-related contract will be considered non-resident. However, California has the most stringent income tax regime among the 'sticky states', with rates ranging from 1% for low earners to 13.3% for higher earners with incomes in excess of US$1 million.

It's worth noting that US citizens living overseas may still be liable to pay state income taxes in California if they have active or passive income sourced in the state or have specific ties to the state, such as where their driver's license was issued, where their cars are registered, where their voter registration is held, where they maintain bank accounts, where their lawyer, accountant, doctor, or dentist are based, where they hold property and investments, and so on.

Moving to another state before going abroad is the best option to avoid this unwanted scenario. For instance, only a handful of US states do not impose state taxes: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. New Hampshire does not tax earned wages but does tax other income sources like interest and dividends.

For the remaining states, each has its own tax rules and applies them in different ways. The IRS determines the source of income based on where the service is performed. To be considered a bona fide resident of a foreign country, you must have been a resident of that country for an entire calendar year.

Lastly, it's important to mention that choosing to expatriate and renounce your US citizenship is a tried and tested means of lowering your taxes permanently, but it's a significant decision with various implications.

In conclusion, understanding the tax implications of living abroad as a US citizen is crucial for managing your finances effectively. Consulting with a tax professional can help navigate these complexities and ensure compliance with both federal and state tax laws.