I've been reading some questions about Americans paying taxes to the US while living and working overseas. I've also been looking around at some linked websites, but I haven't seen anything regarding state/local taxes. If you're an American working overseas, do you only pay federal income tax, or do you also have to pay state income tax (if so, I imagine this would be based on the most recent state lived in, but please correct me if that is incorrect)?
Yes, in most cases you do pay state income tax, unless of course you are able to somehow legitimately claim residency in one of the few states (e.g. Texas) with no state income tax.
It does vary by state, however. For example, Massachusetts residents can claim an exclusion when residing overseas. (http://www.mass.gov/dor/individuals/filing-and-payment-information/guide-to-personal-income-tax/residency-status.html#resworkingoverseas). Check your state's specific guidance.
If you are a U.S. citizen working abroad, you may be able to minimize what you owe in U.S. income tax if you qualify for the foreign income exclusion. If you qualify, you may exclude up to $92,900 in foreign income from U.S. income tax liability in 2011. If you are married, your spouse is allowed an additional $92,900 exclusion. To qualify, you and your spouse must satisfy the following requirements:
1) You must reside in a foreign country for an entire tax year or for at least 330 days during a 12-month period 2) Your salary must be paid by a company or agency in your country of residence or by a U.S. company operating in that country.
Also, only earned income--salaries, wages, and fringe benefits, plus allowances and expenses for housing--qualifies for the exclusion. Dividends, interest, capital gains, pension or retirement distributions, and alimony do not qualify. If you are a member of the U.S. military or other government service and are living abroad, your income is not considered foreign income. You'll have to pay taxes as if you were a taxpayer living in the United States.
Even if you avoid U.S. income tax, you will likely pay some form of income tax to the country in which you reside and earn a salary. Should you fail to meet its residency requirements, or if you receive income above the allowable exclusion, you'll probably end up paying both foreign and U.S. income tax. If you do pay foreign income tax, you can apply for a separate U.S. tax credit (using Form 1116) in the amount of foreign income tax you are required to pay.
You'll also owe U.S. Social Security taxes if your country of residence has no treaty to coordinate its social service coverage with the United States. However, if such a treaty is in force, you'll pay foreign social service taxes to your host nation and will not be required to pay U.S. Social Security taxes. In addition, you may be subject to estate and gift taxes if you transfer property, no matter where that property is located. If you maintain a house in the United States, you may owe state income tax and local property tax. For more information, consult a tax advisor or contact the IRS at (800) 829-3676 or www.irs.gov and request Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.