The Truth About Contractor Tax Math
“So, you don’t pay taxes, right?” is a common question about overseas contracting jobs. Like any good debrief answer, it depends! The short answer is that it depends on two things: how much you earn and how your compensation is structured. In this informational post, we will look at two financial examples with Sally SARM and Pilot Pete.
A Good Four Letter “Word” - FEIE
First, let’s start with the law. Unlike every other country in the world besides Eritrea, Americans are taxed on worldwide income. Although some see it as deeply unfair, the real reason for the law is to make sure the super-rich don’t dodge their fair share by living abroad. I personally just chalk it up to the subscription fee for America if I need SEAL Team 6 to rescue me after being kidnapped on holiday.
Uncle Sam makes it up to us regular folk, however with an important tax provision, the Foreign Earned Income Exclusion (FEIE) which allows the first $126,500 earned abroad as tax free.
From there, it is easy to see that it depends if you are over or under this line. Many maintenance and operations support personnel work abroad and have absolutely zero tax liability. Meanwhile, those with a salary over FEIE or other income streams get a huge tax break that reduces their effective tax rate. They may still get a sizable refund at the end of the year depending on their withholding rate.
How Do Tax Rates Work, Anyways?
Before going into the examples, it is important to quickly reiterate how tax rates work. Working in the service industry before joining the Air Force, I would routinely hear people turn down work because it “was not worth it to work overtime” or they did not want to be “pushed into a higher tax bracket.” This is simply not how it works in 95% of cases unless you are doing advanced things like timing the realization of capital gains or things that my coworkers at McDonald’s were definitely not doing.
Sally SARM’s Tax Rates in the Panhandle
Let’s use Sally SARM as an example to understand the chart below.
Sally is a contractor at Eglin AFB, FL and makes $100,525 per year. This means her final earnings are in the third bracket at 22%. However, while her marginal rate is 22%, her effective tax rate is only 14.3% because she was taxed only 10% on her first $11,600 made and 12% on the next $35,549 she made when she earned up to $47,150. Only her earnings from $47,151 to $100,525 were thus taxed at 22%.
If her generous boss gives her a one-dollar bonus at the end of the year, then only that dollar, which begins the next bracket, will be taxed at the next rate, 24%. The key takeaway is that the marginal change (overage) does not make her whole annual salary taxed at 24%, it remains at 14%.
Source: NerdWallet Table Based on IRS Rules
Sally SARM Goes Abroad – The Implications
OK, so now that we got that out of the way, let’s imagine Sally SARM takes a contract job overseas for the exact same salary amount ($100,525). In this case, because she is under the FEIE amount of $126,500, she effectively has no tax burden.
However, let us update the scenario to say that Sally SARM is a retired E-7 and receives $35,000 from her military retirement. Her new total annual income is $135,525 ($100,525 + $35,000).
Now that we talked about marginal tax rate, you think the answer might be as simple as taking the amount that is over the exclusion, $9,025 and applying the 10% rate to it. Unfortunately for Sally, there is a wrinkle here where US-sourced income cannot be excluded under FEIE. While she has no liability for her income earned abroad, all of her retirement income is subject to income tax. This means that pension plans, capital gains, rental income, and other passive income streams would not count towards the exclusion. Furthermore, while she does not owe a tax liability on the first $105k, for tax purposes, the amount still “stacks” and she is subject to a 24% rate on her $35k of retirement income.
Despite this, Sally SARM still enjoys significant tax savings. Her effective tax rate is 5.31% or $7,200 for her overseas income plus retirement pay. If we assumed she was a retiree working in Florida, she would owe approximately $22,600 in taxes with a 16.6% effective tax rate on $135,525.
Other Tax Gotchas & Benefits
For simplicity, the above example only looked at federal income taxes to explain the FEIE and marginal versus effective tax rates.
For a more complete picture, we must consider state income taxes and FICA taxes (Social Security & Medicare).
State income taxes are not a consideration for residents of Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, and Wyoming. For those that do owe state income taxes, there is a silver lining. Because FEIE adjusts your income lower, the starting point for state taxes will also usually be after FEIE is applied. However, states that are “stickier” about taxes, like California and Virginia, will start at the top line worldwide income.
In this second example, we will ignore state taxes and assume Pilot Pete changed his residency status while at UPT in Florida. We will include FICA taxes in this example. FICA taxes are dependent on your employer. If you work for an American prime or subcontractor, you can still expect to pay FICA taxes of 7.65% on wages up until the $176,100 cap.
If you work for a local company, the good news is that there are no FICA withholdings. The bad side is all the shenanigans that can come with your host nation’s laws regarding taxes, pay, and compensation.
Pilot Pete
Pilot Pete is an example of a salary greater than the FEIE. However, because Pilot Pete bounced as soon as his UPT commitment expired, we won’t consider retirement income, but we would stack it if required like in Sally’s case. We will also take a look at his overall package, so to speak, regarding compensation and see how benefits can change the tax calculus and true take home pay.
On 1 Jan, Pilot Pete moves to Japan to become a sim instructor and is paid a salary of $165,000. In addition to his salary, Pilot Pete gets per diem for being away from home. His firm sets it at the maximum allowable for Misawa using the government rate ($185 per day). For one year, this equals $67,525. His firm also gives him a cash allowance for returning to the United States for R&R that equals $10,000. We will break down benefits and compensation in another post, but this example illustrates that Pete’s before-tax income is more like $242,525 before the value of his other regular benefits – 401k, healthcare, vacation days, etc.
Pilot Pete’s Tax Rates in the Panhandle
How much does Pete earn in Florida? If Pilot Pete made $165k in the Florida, most of his earnings would be taxed at a 24% marginal rate with an overall effective tax rate of 18%.
Since he lives in the area, there are no additional per diem or allowance benefits and his total income tax bill is $29k. If we add the 7.47% effective tax rate for FICA, Pilot Pete now owes a 25% effective tax rate with a $42k total tax bill. His take home pay is almost $10,000 a month for an annual net amount of $123,000.
Pilot Pete Goes to Nippon
In Japan, his effective tax rate on $165k is 13.07% including FICA. Pilot Pete’s taxable income is $38,500 after the exclusion and he owes $9,240 for a sweet effective income tax rate of 5.6%. However, since FICA considers the entirety of income, he will pay $12,234 for Social Security and Medicare taxes. His income tax savings are approximately $8k with total tax savings of about $21k.
However, Pilot Pete has some serious non-tax benefits here that feel like “income” to him regardless of the tax code because it hits his bank account. Consequently, for receiving $242k annually and paying out $21k in taxes, his hypothetical effective tax rate is about 9% and his take home pay is about $220k.
To make this equivalent take home amount domestically, Pilot Pete would need to make $311,000 where he would incur a 29% effective tax rate. That’s a $91,000 tax bill!
Conclusion – Get a Tax Pro & Carry On
As these examples show, you must run the numbers to realize your true tax situation. As every person has a different situation, it is important to find a tax professional that is experienced with expat tax situations. A reasonable amount to pay is between $400 to $1000 depending on the complexity of your tax situation. Ultimately, this is a small price to pay for having a preparer who is an authorized agent that can talk with the IRS for you, can help you amend previous year reports to carry over some potential refunds, and takes the burden off knowing the intricacies of the tax code.
One other mechanism not discussed in this post is the Foreign Tax Credit (FTC). Used with or without the FEIE, it is a way to avoid double taxation if you pay host nation taxes – a situation more applicable to Europe than the Middle East.
The preparer will help ensure that you meet the FEIE eligibility requirements, which can be done by a physical presence test (how many days abroad you are) or if you have established a new “tax home” elsewhere with the overseas assignment. This amount can be pro-rated as well if you take a 30-60 contracting gig or leave during part of the year.
By law, the FEIE applies to contractors in combat tax zones and regular people living and working abroad, such as Pilot Pete in Japan. However, it does not apply to federal employees or the military. Thus, a six-month TDY to Korea cannot be used to invoke FEIE. Deployed members will instead use their own provisions of the Combat Tax Zone Exclusion (CTZE) reflects on their active-duty W-2 forms.
Lastly, don't let tax rates and dollar amounts influence your career decisions too badly. It is a component of evaluating the total fit of a job, its location, work tempo, etc.
Disclaimer
Just realize we are just bros trying to help bros and are not licensed professionals. Seek financial or legal advice as required. For your own reading, you can read more about FEIE here or use a sample tax calculator here.