Taxes on Unearned Income: Rules for US Expats

When most people think about income taxes, they think of the taxes automatically withheld from their paycheck — or, if they’re self-employed, the quarterly tax estimates they pay.

But, what about taxes on unearned income?

Unearned income — also known as passive income — refers to the income you don’t actively work for. This can include rental income, stock dividends, or copyright royalties, among other types. Even if the government doesn’t take withholding from your unearned income, it doesn’t mean you don’t owe them.

The tricky part? Different types of unearned income have different taxation rules. And when you factor in a foreign income source, it can add another layer of complexity.

As US expat tax specialists, we’re here to walk you through it all. Below, we’ll discuss how taxes on unearned income work, which forms you’ll have to file, how to reduce your unearned income tax liability, and more.

Understanding unearned income taxation for US expats

One of the benefits of unearned income is that it isn’t subject to US Social Security or Medicare taxes like employment and self-employment income. Most often, it’s subject to ordinary tax rates of 0% to 37%, depending on your tax bracket — but there are some exceptions depending on the income type.

Types of unearned income

A few common types of unearned income include:

Interest

Interest income includes anything you earn from lending funds, like storing money at a bank or purchasing a Certificate of Deposit (CD). Generally, you pay taxes on interest income at ordinary tax rates in the year you receive it, or it is deposited into your account.

Capital gains

Capital gains refer to the profit you make from selling assets like stocks, property, and cryptocurrency at a higher value than the original price. There are two different capital gains tax rates: short-term and long-term.

The sale of assets held for a year or less will be subject to short-term capital gains rates, the same as ordinary tax rates.

Assets held for over a year before selling, though, trigger more favorable long-term capital gains rates. Long-term capital gains rates are either 0%, 15%, or 20%, depending on your overall income bracket.

Retirement account withdrawals & distributions

You can generally begin to withdraw from qualified retirement accounts without penalties at age 59 ½. If you lose or leave your job in a calendar year when you’re 55 or older, you can also withdraw penalty-free. If you withdraw before that, you’ll usually be subject to a 10% penalty (with a few exceptions, like unreimbursed medical expenses, disability, or death of the IRA owner).

B!T note: You can withdraw from your Roth IRA or Roth 401(k) without penalty before retirement age if your withdrawal does not exceed your contributions.

By age 72 or 73 (depending on your birth year), you must begin withdrawing from your retirement accounts and take what are called required minimum distributions.

You usually don’t pay taxes on post-tax retirement account distributions from Roth IRAs and Roth 401(k)s. However, withdrawals that don’t meet the qualifying distribution criteria are subject to ordinary tax rates and a 10% penalty. 

Withdrawals from pre-tax retirement accounts — like 401(k)s, traditional IRAs, and pensions — are subject to ordinary income tax rates. Again, non-qualified distributions incur a 10% penalty.

Trust fund distributions

Trust fund distributions are assets or cash granted to a beneficiary by a trust. Generally, distributions from a trust’s principal balance are tax-free for the beneficiary. However, beneficiaries must pay ordinary income tax rates on distributions from a trust’s gains or interest.

Lottery winnings

Payouts you receive after winning the lottery incur ordinary income tax rates. Your net earnings will be added to your overall income, which may bump you up to a different tax bracket. Beyond that, the Internal Revenue Service (IRS) automatically withholds 30% of net lottery winnings in anticipation of the tax due on the tax return. 

The first $599.99 of your winnings is tax-free, and you don’t need to report it on your income tax return. Generally, choosing to receive distributions over an extended period versus taking out a lump sum is more tax efficient.

Dividends

A dividend is a distribution of a company’s profit passed along to its shareholders. Like capital gains income, dividend income has two different tax rates, depending on whether it’s an ordinary or qualified dividend.

Ordinary dividends incur ordinary tax rates, while qualified dividends incur preferential tax rates. Qualified dividends are dividends that have been:

• Paid out by a US company or a company that trades and/or has a tax treaty with the US government
• Held for a certain amount of time before you received the dividend (usually 60 or 90 days, depending on the type)

Qualified dividend tax rates are either 0%, 15%, or 20%, according to your overall taxable income level (just like long-term capital gains).

ETFs & mutual fund distributions

Exchange-traded funds and mutual funds are investment vehicles that pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities. Typically, distributions from these funds happen in two ways: through dividends or capital gains distributions.

Like traditional dividend income, dividend distributions from ETFs or mutual funds attract ordinary or preferential tax rates based on whether they are ordinary or qualified. Capital gains distributions, similarly, attract tax rates based on whether they relate to short or long-term holdings.

Rental income

As its name implies, rental income is income you receive in exchange for renting out property you own. The US government taxes rental income at ordinary rates. It’s worth noting that rental income can be offset with allowable expenses, such as:

• Property management expenses
• Maintenance costs
• Property taxes
• Mortgage interest
• Utilities
• Advertising
• Insurance
• HOA fees
• Travel costs to and from the property

What’s more, you can also claim depreciation on the property.

Royalties

Royalties are legally-binding payments you earn when someone uses your property. This property includes copyrights, patents, and land where oil and gas companies drill. Royalty payments are subject to ordinary income tax rates.

Social Security benefits

If you’ve earned enough Social Security credits, you’ll be eligible to receive benefits beginning at 62 (or sooner if you become disabled). However, the amount that you receive changes depending on your age:

• Early retirement (62-66): Receive about 70% of standard Social Security benefits
• Full retirement (67): Receive full Social Security benefits
• Delayed retirement (68-70): Receive full Social Security benefits plus 8% for each year worked after retirement age

You must pay taxes on your Social Security benefits if your combined income exceeds $25,000 (or $32,000 for married couples filing jointly). However, depending on your overall income level, only 50% or 85% of Social Security benefits are subject to taxation.

Tax forms & filing requirements

A few tax forms, schedules, and reports you may need to file if you have unearned income include:

• Form 1040: The cover page, of sorts, for your US tax return, as a US taxpayer. This form summarizes the income reported on other schedules and disclosures. 
• Schedule B: For reporting interest income, dividends
• Schedule D: For reporting capital gains
• Form 8606: For reporting nonqualified Roth IRA and Roth 401(k) withdrawals
• Schedule E: For reporting royalties, rental income allowable expenses, and trust fund distributions

• Form 5329: For reporting early 401(k) withdrawals
• Form 4562: For calculating rental property depreciation
• Form 8621: For reporting foreign mutual funds
• FinCen 114: Mandatory for those with foreign financial accounts totaling over $10,000
• Form 8938: Mandatory for those with foreign financial assets valued at over $200,000 on the last day of the tax year, or over $300,000 at any point during the tax year

Taxation of foreign unearned income

All US permanent residents and citizens are subject to taxes on their worldwide income, which includes foreign-source income as well as US-source income. The government sometimes taxes foreign unearned income differently than domestic unearned income. If you’re struggling to understand how you should pay taxes on your foreign unearned income, we always advise consulting a tax professional to ensure accuracy and avoid potential IRS penalties.

Expat-specific considerations to keep in mind

• Double taxation on unearned income: Expats who are tax residents of another country may have the same unearned income taxed twice: once by the US, and again by their country of residence. Fortunately, there are mechanisms to avoid this double taxation (more on that in a bit).
• Tax treaties may offer benefits — or not: The US has tax treaties with dozens of countries that prevent double taxation, in theory. However, most contain saving clauses that let the IRS tax Americans as if the treaty didn’t exist. That said, some benefits may survive the saving clause.
• Capital gains benefits for foreign property: Capital gains are calculated by subtracting an asset’s purchase price from the selling price. When it comes to foreign property, Americans abroad can add the following costs to the purchase price:
  • Costs of improvements with a useful life of more than one year (new roof, additional bedrooms, fences, etc.)
  • City or county assessments for local public improvements
  • General sales tax imposed on the purchase
  • Settlement charges from the purchase or sale, including fees, title fees, attorney fees, and commissions
  • Commissions and fees relating to the sale/purchase of stocks and bonds
• Higher tax rates on foreign mutual funds: The US government typically labels foreign pooled investments (like investment trusts, ETFs, and sometimes even foreign corporations and pensions) as Passive Foreign Investment Companies (PFICs). Taxes on PFICs are generally much higher and more complex than domestic mutual funds.
• Foreign dividends may not be qualified: Only foreign dividends issued by a company that trades or has a tax treaty with the US government are eligible for the more favorable qualified dividends tax rate.
• Tax-advantaged account contributions must come from earned income: You cannot contribute unearned income or income excluded under the FEIE to a US-based tax-advantaged account.
• Alternative depreciation system: Depreciation on foreign rental real estate is over 30 or years (depending on when it was first rented) rather than 27.5 years, as is standard for US rental real estate.

Reducing unearned income tax liability 

Foreign Tax Credit (FTC)

The FTC is one of the best ways to reduce US tax liability on unearned income. Expats who claim the FTC earn dollar-for-dollar US tax credits with any foreign income taxes they’ve paid. This allows you to essentially subtract what you’ve paid in foreign income taxes from your US tax bill.

However, the FTC is less effective if you pay taxes in a country with lower rates than the US. Claiming the FTC for taxes you’ve paid on foreign unearned income in a country with lower tax rates than the US would only partially offset your US tax liability.

To qualify for the FTC, taxes must be:

• Based on income
• Legal
• Paid or accrued
• Due by you specifically

Waiting to sell assets

Holding onto assets for over a year before selling them will result in a more favorable long-term capital gains tax rate of 0%, 15%, or 20%, depending on your income. 

Holding onto dividends for at least the minimum holding period (again, typically 60 to 90 days), meanwhile, improves your odds of receiving the more advantageous qualified tax rate (0%, 15%, or 20%), which can result in tax savings of up to 17%.

Tax treaties

Some US tax treaties contain benefits that survive the saving clause and allow you to reduce your US tax liability on unearned income. For example, the US-UK tax treaty allows Americans living in the UK to make a one-time, tax-free lump sum pension withdrawal of up to £1,073,100 (~$1,356,855).

Optimize your tax strategy & file stress-free

As you can no doubt tell by now, taxes on unearned income — especially foreign-sourced unearned income — are complex. Understanding the current tax laws and keeping up with developments can help you make more informed tax and financial decisions. That said, there’s no substitute for expert advice from a tax professional.

Resources:

1. Interest Income and Taxes
2. Interest Income
3. Retiring Early? 5 Key Points about the Rule of 55
4. Early Withdrawal Penalties for Traditional and Roth IRAs
5. 401(k) Taxes on Withdrawals and Contributions
6. Are Trust Distributions Taxable?
7. How To Avoid the Double Taxation of Mutual Funds
8. ETFs vs. mutual funds: Tax efficiency
9. How Is Rental Income Taxed? A Guide For Real Estate Investors
10. What Is a Royalty? How Payments Work and Types of Royalties
11. Retirement Benefits
12. Income Taxes and Your Social Security Benefit
13. Types of Income the IRS Doesn’t Tax
14. United Kingdom – Individual – Taxes on personal income