Reducing your US taxable income for the first five years in Spain

If you are taking advantage of the 24% special rate for expats in Spain and are a US citizen, you may be in a somewhat sucky situation where you need to “top-up” your US taxes to whatever marginal rate you pay in the US.

Eventually you will run out your 6 years and then you will be back to paying much more in Spanish taxes than US. Unfortunately you can only carry back any extra credits one year, so you may end up paying a bunch of US taxes for the first five years, and then pay extra taxes in the following years in Spain.

If you are salaried employee and don’t have a lot of deductions, there aren’t a lot of options (unless you own a house with a big mortgage). Here are the ways you can reduce your income for the first five years (and potentially shift it to the years following your Spanish tax increase when you can credit against what you are paying already):

• IRA Individual contribution: $5000 that is deductible from your income as long as you are not covered by a US qualified retirement plan.
• HSA (Health Savings Account) contribution: $6450 per family. This is pretax and can be spent on any qualified medical expense. It can also be invested pretty much like an IRA or 401K (search for HSA brokerage). If you use this for non-qualified expenses, you pay a 20% penalty. In order to qualify, you need to only have a high-deductible insurance plan. Not sure whether the fact you are covered by the public system in Spain would affect that.
• Childcare tax credit: if both spouses work, you can get a tax credit of up to $1200 for qualified child care expenses. This can include a nanny and doesn’t have to be a US citizen (or have a US provider number) if you live outside the US.

I didn’t find that earned income exclusion helped in reducing my taxes (since you have to also exclude any credit for taxes paid on the excluded income). Some people take the foreign exclusion and then don’t reduce their foreign tax credits according to the instructions and end up paying zero taxes, but that’s just cheating. The new harsher penalties around with foreign income make it an especially bad idea.

Remember that for year six, you still have to pay your US taxes as always, but once you finish year seven, you can carry back any excess foreign tax credits to the year before and file an amended return to get your money back. Be especially careful not to make any mistakes on your US return for the final year at 24%, since filing an amended return to get a big refund is likely to expose you to extra scrutiny.