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Last Updated on October 10, 2024 by Rashad Bolbol
In a previous article, we discussed Canada’s departure tax and how it impacts Canadians who leave the country. In this article, we’ll turn our focus to the US exit tax, which applies to individuals who give up US citizenship or long-term residency. If you’re thinking about leaving the US tax system, understanding the exit tax is essential for careful planning—and it could save you a lot of money.
What Is the Exit Tax?
The US exit tax applies to those who either relinquish their US citizenship or are long-term residents (green card holders for at least 8 out of the last 15 years) who choose to stop being US residents. It’s a way for the US government to ensure that all taxes are paid on your assets before you leave the US tax system.
Who Has to Pay the Exit Tax?
Not everyone is subject to the exit tax. The tax only applies to “covered expatriates.” You’re considered a covered expatriate if you meet any of the following conditions:
- Your net worth is $2 million or more on the date you expatriate.
- Your average annual tax liability for the last five years before expatriating is more than $201,000 (for 2024).
- You have not complied with your US tax obligations for the last five years and cannot certify that you did on Form 8854.
If you meet any of these conditions, you’ll need to pay the exit tax.
How the Exit Tax Is Calculated
The exit tax works by treating all your assets as if you sold them the day before you leave the US This is known as a “deemed sale” or “mark-to-market” tax. The US will tax any gains from this imaginary sale, just like it would if you had sold these assets for real.
Example: How the Exit Tax Might Work
Let’s say Jane is a US citizen with the following assets:
- Stocks and investments: worth $1.5 million with a $600,000 gain.
- Home: valued at $800,000 with a $300,000 gain.
- IRA (retirement account): $500,000.
- Foreign pension: worth $200,000.
Jane decides to expatriate in 2024. Because her net worth is more than $2 million and she meets the tax liability test, she’s a covered expatriate.
Here’s how the exit tax might look for Jane:
- Mark-to-market tax on stocks and home: Jane would calculate her capital gains ($600,000 on stocks and $300,000 on her home). There is an exclusion amount of $866,000 in 2024, which means Jane can subtract that from her total gain. After the exclusion, Jane would be taxed on $34,000 of capital gains.
- IRA: The entire amount in Jane’s IRA ($500,000) is considered fully distributed and taxed as ordinary income.
- Foreign pension: This is treated as ineligible deferred compensation and taxed as a lump-sum distribution at ordinary income rates.
Why Planning Matters
The exit tax can be complicated and costly, but with careful planning, it’s possible to reduce your tax burden. Here are some strategies that can help:
- Timing Your Expatriation: If you delay expatriation, you might be able to lower your net worth or average annual tax liability, so you don’t meet the covered expatriate thresholds.
- Gifting or Transferring Assets: If you give away or transfer assets before expatriating, it could reduce your net worth and lower your potential tax bill. However, these gifts need to be planned well in advance to avoid gift taxes.
- Retirement Account Planning: For those with large retirement accounts, you might want to explore options for rolling over or withdrawing funds before expatriation, depending on your specific situation.
- Trusts and Estates: If you have assets in trusts, there are specific strategies, such as restructuring the trust or transferring assets out of it before expatriation, that could help reduce your tax liability.
The bottom line is that proper planning can save you a lot of money. Without it, you could be hit with a large tax bill and ongoing US tax obligations even after you’ve given up citizenship or residency.
Final Thoughts
Expatriation is a big decision with significant financial implications. The US exit tax can seem overwhelming, but understanding it is the first step. With the right planning, you can reduce your tax burden and avoid surprises down the line. As we’ve seen in the example of Jane, each type of asset is treated differently, and working with an experienced tax advisor can ensure you make the best decisions for your situation.
If you’re interested in learning more about expatriation and tax strategies, reach out to our team of tax experts for advice. And for those considering expatriation from Canada, don’t forget to check out our previous article on Canada’s departure tax. Planning ahead can make all the difference!