Do US Expats Pay State Taxes?

Aside from its breathtaking beauty and being the most populous island in Samoa, Upolu boasts a rather more dubious claim – it’s home to the remotest McDonald’s restaurant on earth.

Located some 770 kilometres from the company’s next outlet in Fiji, the restaurant is, perhaps unsurprisingly, a hit with both locals and tourists.

For many, the golden arches have come to symbolise the global spread of American culture through its fast food, fast music and expat nomads. And it’s undeniable that the Big Mac and Taylor Swift continue to bestride the world as American icons.

But that other export, the American expat, finds themselves tethered by an inescapable reality – the obligations of citizenship know no bounds and the world isn’t a big enough place to hide from the long arm of the US Internal Revenue Service (IRS).

As a US citizen, you are also a US tax resident by default under its worldwide tax system. As such, you probably know that you have to file a federal tax return regardless of where in the world you live, but did you know you may also need to file a state tax return?

Only a handful of the 50 US states do not impose state taxes: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming. Similarly, New Hampshire does not tax earned wages. So, if you’re from one of these states, you don’t have to worry about income tax. 

For the remaining states, as you would imagine, each one has its own tax rules and applies them in different ways. Generally speaking, though, each of these states will tax income that is received there. This includes rental income on properties that are located within the state. In addition, sometimes other passive income sources, such as pension payments or interest dividends, could be taxable within a state and create a filing requirement. 

That said, most states will only require that you file a state tax return and pay state income tax if you have lived in that state during the relevant period. They’ll also allow you to exclude part of what you earn overseas under the Foreign Earned Income Exclusion (FEIE). 

How Does Foreign Earned Income Exclusion Work?

It’s no secret that all US citizens who live overseas pay tax on their worldwide income. This means they must file Form 1040 (Individual Income Tax Return) to report their worldwide income. If you have foreign income, foreign companies or foreign bank accounts, you’re legally required to report them. However, in some cases, the IRS does allow you to earn some tax-free money by claiming the FEIE.

The FEIE is a long-established way for US citizens living abroad to limit their tax burden. Currently, it allows qualifying individuals to exclude the first US$126,500 for tax year 2024. Read our ultimate guide to the FEIE here. 

However, this is not a total exemption from all tax responsibilities. For the purposes of the FEIE, the IRS breaks your income into two categories: active and passive.

Active income is income you actively earn through your work activities and includes salary, wages, bonuses or self-employment income you earn while working in a foreign country. This active income can also include earnings from a US-based business or client. If you earned the money while living and working overseas you qualify for FEIE, even as an employee of a US-based company.

On the other hand, any form of passive income is not excluded from federal income tax. Passive income is earned from activities such as stocks and forex trading, crypto trading, capital gains, profits from selling real estate, pension income, Individual Retirement Account (IRA) distributions, rental income, social security benefits and so on. It is taxed without exception.

One key factor about earned income is that the IRS determines the source of income based on where the service is performed.

For example, you could be living in Spain but working for an American company and being paid by that company. This income would still qualify for the Foreign Earned Income Exclusion as long as you were considered a resident of Spain.

So, to reduce the amount of tax you owe by excluding certain types of income under FEIE rules, you must meet specific criteria to demonstrate you have a tax home in another country. The two ways of doing this are by meeting the requirements of a Physical Presence Test and a Bona Fide Residence Test.

The Physical Presence and Bona Fide Residence Tests

Passing the Physical Presence Test is the easiest way to qualify for the FEIE and involves being in a foreign country, or countries, for 330 out of any 365-day period. However, being in a foreign country is not the same as being outside the United States. 

Time spent in international waters does not count towards the 330 days, for example, if you’re on a family vacation abroad or a foreign cruise. Likewise, any part of a day spent in the United States is not considered a foreign day. 

Therefore, if you’re qualifying under the physical presence test, you must pay close attention to the number of days that count as foreign days to make sure you reach 330 days. You can choose any date to begin the 330 days; it doesn’t need to be a calendar year.

The Bona Fide Residence Test is the more difficult of the two tests and requires you to maintain ties in one foreign country where you hold a residence permit or citizenship. To qualify, you must show social, financial and other ties to a foreign country.

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. This makes it difficult to qualify for the bona fide residence test in the first year that you move out of the United States.

So, in most cases, a US citizen or resident living abroad will qualify in year one under the physical presence test and then, in year two, meet the bona fide residence test.

The benefit of this more subjective test is if you can show bona fide residence in another country, you can spend up to an average of 120 days in the US each year.

‘Sticky States’ That Make It Harder

Even if you live overseas, however, some ‘sticky states’, as they are known, make it harder for you to end your residency and claim FEIE. The following states do not allow the Foreign Earned Income Exclusion: California, Colorado, Hawaii, Massachusetts, New York, and South Carolina.

Of these ‘sticky states’, California, however, has the most stringent income tax regime. Under its rules, Californian citizens living overseas may still be liable to pay state income taxes if they no longer live there. If you have active or passive income sourced in the state or have specific ties to the state, you could still be considered a resident for local income tax purposes.

If the state of California can show you have closer connections there, regardless of where you live, they will deem you a resident. These connections include factors like:

• how much time you spend in California versus that spent elsewhere
• where your driver’s licence was issued
• where your cars are registered
• where your voter registration is held
• where you maintain bank accounts
• where your lawyer, accountant, doctor or dentist are based
• where you hold property and investments.

The strength of these ties, rather than the number of them, count towards residency. But clearly, the more factors you have, the stronger the State of California will claim you’re still a resident. In that case, you’ll need to continue to file a tax return even if you have left.

You continue to pay taxes on income sourced in California before your move abroad, regardless of whether you’re considered a resident or non-resident. 

This can include wages or salaries earned in California, rental income and sale profits from real estate in California, freelance earnings in the state, investment income and pension distributions. State income tax rates in California range from 1% for low earners to 14.4% for higher earners with incomes in excess of US$1million. 

So be warned – US citizens residing abroad who previously lived in California may still be liable to pay California state income taxes and not be eligible to apply FEIE to their state tax bill.

This means that if they pay foreign taxes in their new country of residence, they could be subject to double taxation, depending on local tax rules.

Moving to another state before going abroad is the best option to avoid this unwanted scenario. As an expat, you must eliminate ties to certain’ sticky’ states to qualify for FEIE and not be liable for US state taxes. 

Moving your residence to a state with no state tax or making qualifying for FEIE easier can bring considerable tax benefits, especially if your ultimate goal is to live overseas. 

To do that, you’ll need to eliminate ties to your original ‘sticky state’ by selling your home – or ending your lease if you rent – moving your immediate family, closing any bank accounts in the state, and cancelling your voter registration, driver’s licence, library card and so on. You must show you have no intention to return. If you own a company you may also want to re-domicile it to your new state.

The other way to be eligible for FEIE and avoid state taxes is to meet conditions for safe harbour.

What Is the Safe Harbor Rule?

The Safe Harbor rule allow you to claim FEIE while living abroad when certain conditions are met. States such as California and New York have their own versions of Safe Harbor rules.

For example, 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.

Therefore, if you moved overseas from California, you have to be out of the state for a year and a half to be deemed non-resident for state tax purposes and show you do not plan to return. 

Under Safe Harbor rules, you can visit California as long as you don’t spend more than 45 days per year there. Two exceptions to the Safe Harbor rule exist: you earn more than US$200,000 in passive income a year while abroad or your sole aim in moving abroad is to avoid taxes.

How to Pay Lower Taxes as a US Citizen

Even though the long arm of the United States IRS extends to practically every corner of the globe, there are perfectly legal ways to reduce your taxes as a US citizen. 

It could involve taking advantage of the exclusions available to curb the amount of federal income tax you pay and employing strategies that will limit or remove your exposure to state taxes.

Ultimately, however, when it comes to the IRS, you can run but you can’t hide.

That’s why choosing to expatriate and renounce your US citizenship is a tried and tested means of lowering your taxes permanently. It takes planning to get a second passport and ensuring you have the ideal mix of location, lifestyle, tax planning and asset protection strategies working in combination to achieve your goals. 

You can also lower your taxes without renouncing by choosing to live overseas tax efficiently or moving to Puerto Rico, where you can remain on US soil and dramatically reduce your taxes. But whatever you decide to do, it must be structured properly and your strategy will need to incorporate the best solutions among all available options.

Freeing up your money from high levels of taxation is a stepping stone to creating greater wealth and a lifestyle you enjoy. This strategy is part of what we call ‘going where you are treated best’ and looks different for each of the 1500+ high-net-worth individuals we’ve helped. 

We discern what’s best for you by getting to know you, asking the questions that matter, doubling down on what’s important to you and working with you to create a bespoke, holistic action plan.

Rest assured, our global team of over 60 professionals and country-specific advisors will leave no stone unturned when it comes to helping you win personal and financial freedom.

And we’re very good at what we do. 

So, if you’re a US citizen reviewing your options, take the first step towards your new life and discover the Nomad Capitalist difference here.