Totalization Agreements: A quick review

One of the many issues facing Americans working abroad is mitigating double taxation. With “normal” taxes, there are tools such as the foreign earned income exclusion or foreign tax credits. For freelancers or self-employed taxpayers, there is another category called payroll taxes. Payroll taxes include social security and Medicare and are around 15.3%. Taxpayers may be in for an unfortunate surprise come filing time, to find out that the normal foreign exclusion/credits cannot be applied to payroll taxes. The best way to avoid them is through International Social Security treaties that the Social Security Administration has called “Totalization Agreements”.

Totalization Agreements recognize that self-employed people working abroad may be paying into the social security program in their country of residence. Paying the non-progressive 15.3% to the US, on top of paying the equivalent in their resident country, can be punitive. For example, a taxpayer living in a country without a Totalization Agreement earning $100,000, paying 25% on “normal” income, and 10% on their self-employment income will pay $15,300 more than their counterpart living in a country with a Totalization Agreement. This example is illustrated below.

The punitive cost of a non-Totalization Agreement country will always be the total self-employment payroll taxes paid to the US. The social security administration themselves show that it can result in 65-70% effective tax rates. If your resident country has no social security program or you do not pay into it, there is no punitive cost. This can be reduced by claiming a deduction for half of the self-employment taxes, which is beneficial if the foreign exclusion/credit has not resulted in no tax due. The payroll taxes comprise of three things:

1. 2% of social security on the first $147,000 of income (2022, indexed annually)
2. 45% of Medicare taxes (unlimited)
3. 9% of additional Medicare taxes on earnings in excess of $125,00-$250,000 (depending on your filing status)
4. Number 1 and 2 are doubled to count the employee and the employer’s contribution, resulting in the 15.3% mentioned above

There are 30 countries that have a Totalization Agreement with the US, listed below. The Social Security Administration is working behind the scenes to get more agreements with more countries, so if yours is not on the list, please keep an eye out. Slovenia and Iceland were both added in 2019.

If you live/work in one of the countries above and have self-employment income, make sure to have a conversation with your tax preparer/consultant. The logistics of claiming an exemption on your tax return are simple. First, you should have a statement that says “Exempt” on Line 4 of Schedule 2 (2020). Second, a sentence or two should be added in a supplemental attachment elaborating on the exemption. A treaty-based position (Form 8833) is not necessary.

It’s not all bad, however, as paying into the US social security system has its advantages. There are a few upsides for those living/working in a country that does not have a Totalization Agreement with the US.

1. It reduces the necessary credits to qualify for social security. Normal recipients need 10 years (or 40 quarterly credits) to qualify. With Totalization Agreements in play, taxpayers can qualify with less than the 40 credits.
2. Paying into the US’ system will increase your eventual social security benefits from there. However, Medicare does not provide coverage for foreign health care.
3. For married social security recipients, spouses can continue getting benefits upon death of the original recipient.
4. The higher benefits also will lower the reduction from the Windfall Elimination Provision—a provision that reduces your social security benefits by a certain amount based on the amount you receive from the other country.
5. The US allows for a deduction of half of the payroll taxes (7.65%). Depending on the circumstances of the taxpayer, this deduction may or may not result in ultimate tax savings.

Another potential exception is exploring if you are a common-law employee from the US’ perspective with your tax preparer/consultant. Common law employees are not subject to self-employment taxes. However, they are not allowed any deductions from their gross income.

Regardless of where you live, if you’ve ever paid into the US’ social security system and/or are planning to get some US social security benefits, taxpayers should monitor their annual social security statement through their ssa.gov account. All the information provided herein is general, and each person’s specific circumstances should be considered before making social security-related decisions.