Last week we talked about reporting foreign income and values to the IRS. During that discussion, I mentioned that a taxpayer is actually taxed on their worldwide income. I think this surprised some people so today I want to expand this topic.
I have not really thought about it, but I guess it makes sense that someone would get taxed on their worldwide income.
- Yes, the IRS looks at all your income. Now it is not all taxed the same way, but it is looked at.
What do you mean by not being taxed the same way?
- If you are US citizen, but you live and work outside of the US for much of the year, the income has to be reported to the IRS but some or all of may not be taxable. This is called the foreign income exclusion. This is too complex to talk about today.
- If you are active duty military and working outside the US, there are certain situations where the income is also not taxable.
If we narrow it down, what about someone who has income in multiple states, how is that reported?
- That gets a little more complicated as each state will want to tax you on the income earned in their state.
- Let’s say that you are a Wisconsin resident, but you work in Minnesota.
- Minnesota will tax you on the income earned in their state.
- But Wisconsin (which like most states tax its residents on their worldwide income) will also want to tax you on the Minnesota income.
So do they end up paying tax in both states?
- They would if not for a tax credit.
- What many states do, is to give a state tax credit for the amount of state tax paid to the other state.
- So in our example, any tax paid in MN would be allowed as a credit against the WI tax, so that you are not paying tax twice on the same income.
That makes sense, but what about a state that has no income tax like Florida?
- We have a number of clients who are Wisconsin residents, but they spend winters in Florida and have a job down there.
- Since they are WI residents and they are taxed on their worldwide income, this Florida income would be taxable to WI.
- Florida has no income tax, so there is no state tax credit. Essentially, you would pay WI tax on that income earned.
Is there a way around this?
- Become a resident of Florida.
Do some states have agreements with each other?
- Yes, some states have what is called reciprocity. Under these agreements if someone is a resident of one state and work in another, they only need to file their home state return.
- Wisconsin for example has reciprocity with Illinois. WI residents do not need to file an IL return if they work in that state.
So this week we talked a lot about individuals, next week I want to talk about how this affects businesses. Be sure to talk to a tax professional if you have any questions about Backdoor Roth IRAs or would like further assistance.