Totalization Agreement:
The US has entered into totalization agreements with several countries including the UK, to avoid the double taxation. This agreement prevents US expats living in the UK from paying social security/Medicare taxes to two countries at the same time. With the totalization agreement, contributions can be made to either country – which country depends on how long you will stay in the UK. If you are planning to live in the UK for up to five years, you should continue paying social security/Medicare taxes to the US. If you intend to live in the UK for longer or are unsure about how long you will live in the UK, you should instead pay these taxes in the UK.
Those working for a US employer in the UK and those who are self-employed are generally required to continue paying these US social security contributions. Those working for a foreign firm generally don’t have to. But, keep in mind, if you’re paying National Insurance in the UK it’s likely you won’t have to pay Social Security and Medicare in the US.
If a US citizen or Green Card Holder lived in the UK for 7 years and therefore paid their National Insurance contributions to the UK in this time, these contributions would count towards US social security benefits for when they retired.
Foreign Tax Credit:
If you are a US expat living and earning in the UK and have either paid or accrued UK taxes, you will benefit from using the IRS’ foreign tax credit. Under this programme, you can take your foreign income taxes as US tax credit to reduce your US tax liability.
You can claim credit for foreign taxes that were ‘imposed’ on you, which really means a tax deducted from your wages. In general, only income taxes (wages, war profits and excess profit taxes) qualify for the credit.
The amount of foreign tax that qualifies does not necessarily equal the amount of tax withheld by the foreign country, due to tax refunds. In order to qualify for credit, the amount of tax must be reduced from any refunds made to you.
How to file for Foreign Tax Credit:
In order to claim the foreign tax credit as an individual, you need to file IRS Form 1116 with your US tax return. Before completing Form 1116, all of your foreign taxes paid will need to be converted into US dollars. The IRS prefers this to be converted to the foreign exchange rate at the date of each transaction, but for practical reasons, you can use the IRS foreign exchange set rate for the year, for most income types. To help, the IRS provides annual average exchange rates on their website which you can use.
When it comes to Capital Gains, you need to use the Foreign Exchange rate on the day of the transaction. Many internet sites such as xe.com provide historical exchanges rates that you can rely on.
