Income tax for a nonresident
As a nonresident tax filer, it is important to know which categories your income falls in and how it will be taxed on your nonresident tax return. In this article, you will learn the two categories of U.S. source income and determine if they are taxable. Also, we will go through employment taxes for a nonresident.
In the United States, a nonresident’s U.S. source income falls into two categories:
- Effectively connected income
- Non Effectively connected income
Effectively connected income:
This is income that is connected to a U.S. trade or business. This income is taxed at the same rate as U.S. citizens and residents.
Non Effectively connected income:
This is income that is not connected to a U.S. trade or business. This income must be reported on Form 1040NR and no deductions can be taken against it. This income is taxed at a flat rate of 30% unless a lower treaty rate applies.
Let’s go over some U.S. income sources and determine whether they are effectively connected or non effectively connected. Also, we will determine which income sources are taxable.
Wages, Salaries & Tips
First, let us take a look at Wages, Salaries, and Tips. This type of income is effectively connected income and is generally subject to tax at the same rate as the U.S. tax brackets for citizens and residents.
Second, let us examine Interest Income. Generally, any investment income is treated as not effectively connected with a U.S. trade or business. This includes dividends, capital gains, rental income, and interest, with the exception of bank interest.
U.S. source interest received on deposits held in the banking business (on your bank account) is excluded from a nonresident’s income; you do not even need to report it on your nonresident tax return.
The interest you’ve earned from any source other than a U.S. bank account, is taxable but the interest income you’ve earned from the “banking business,” is not taxable and does not need to be reported on your nonresident tax return.
The banking business includes: commercial banks, mutual savings banks, cooperative banks, credit unions, domestic building and loan associations, and other savings institutions chartered and supervised as savings and loans or similar associations under federal or state law.
Third, we will look at Dividend income. This income is non effectively connected income. If a nonresident student invests in the stock market and receives dividend income, it is not considered effectively connected with the person’s trade or business of studying.
This income is reported on Form 1040-NR. The brokerage firm should have reported that income to the taxpayer on Form 1042-S and withheld a percentage of it for income tax.
If the nonresident did not tell the brokerage firm that they aren’t residents, the income would be reported on Form 1099-DIV, in which case it is likely that taxes were not withheld from it. Since this income is non effectively connected to a U.S. trade or business, this would be taxed at a 30% tax rate.
Scholarships & Fellowships
Additionally, let’s examine income from Scholarships and Fellowships. Income from Scholarship or fellowship can either be non taxable (excludable by the IRS section 117 exclusion), taxable, or exempted by a treaty.
In section 117 it says that a student’s scholarship or fellowship grant is excludable (or in other words, the student does not need to pay taxes on the scholarship or grant) if it only pays for tuition, fees, books, supplies, and equipment that the student is required to buy.
So, if your scholarship or fellowship only pays for your school expenses, then you do not need to report it on your nonresident tax return.
In section 117 it says that the only part of the scholarship or fellowship which will be taxed would be the amount which paid for room and board, travel or any other living expenses.
Additionally, if the student must perform services for the scholarship, then the amount will be taxed.
For example, Resident Assistant (RA) programs who pay a stipend to students or a teacher’s assistant position who pays an amount of money to the student for services performed, the amount paid will be taxed at a 30% rate and reported on form 1042-S.
Exempted by a Tax Treaty
In the event that your country has a treaty exemption, then, you would be allowed to exclude the scholarship income from your tax return or in other words, you won’t be required to pay taxes on the amount.
Next, let’s look at Gambling Income. Some nonresidents receive income from gambling. This income is not effectively connected with the reason for their visit to the U.S. This income must be reported on their return and will be taxed at a 30% rate.
Capital Gains or Losses
Lastly, let’s examine Capital Gains or Losses. Capital gains or losses are considered to be non effectively connected income. Nonresident students are subject to a 30% tax rate for U.S. capital gains unless a tax treaty allows a lower rate.
Payroll for a Nonresident tax return
To determine how much taxes should come out of your paycheck as a nonresident tax filer, you must understand the withholding of tax.
The withholding of tax is the amount of your pay which is taken from your paycheck by your employer and sent to the government as a payment towards our nonresident tax income.
Because you are a nonresident, an employer may make one of two mistakes if you do not specify how much to withhold from your paycheck. The first mistake an employer can make is removing unnecessary taxes from your pay such as social security taxes and medicare taxes. As a nonresident tax filer, you are not required to pay those two taxes.
The other mistake your employer can make is not removing any taxes from your paycheck at all. This means that you haven’t paid any taxes throughout the year and you will have a huge tax bill. Both mistakes can be avoided if you have the correct amount of taxes deducted from your paycheck.
In most cases, nonresidents must pay taxes on any amount of money made in the U.S. As described in Tax Accountable tax course, income which is effectively connected is taxed the same as U.S. citizens and income which is non effectively connected is taxed at 30% unless your country has a reduced rate through a tax treaty.
If you have income that is effectively connected such as money made from wages, salaries, and tips, this type of income is generally subject to tax at the same rate as U.S. citizens and residents.
According to the U.S. tax tables for 2020, if a persons income for the year is $9,875 or less, then that person is required to pay 10% for taxes. If the persons income for the year is between $9,875 and $40,125, then they are required to pay 10% for the amount below $9,875 and 12% tax for the amount above $9,875 (See full U.S. tax table for 2020 here).
If you have income which is non effectively connected such as money made from scholarships which did not pay for your school expenses but used for living expenses (income for being an RA), then this type of income is generally subject to a 30% tax rate.
So, whether you made $500 or $2,000, you must pay 30% tax on the amount. Usually, a nonresident’s university will deduct this automatically from his/her compensation.
So, how much taxes should come out of your paycheck?
If you expect to have income for the year which is less than $9,875, then we recommend that 10-12% be taken from your paycheck for taxes according to the U.S. tax tables. If you expect to have income for the year which is greater than $9,875 but less than $40,125, then we recommend that 12-14% be taken from your paycheck.
In order for a nonresident to request an amount to be removed from their paycheck, they must go to their payroll department to edit their form W4 box 4c amount. Box 4c is the amount of additional withholding you want to remove from your paycheck every time you get paid. This amount taken will go directly to the tax office to pay your taxes throughout the year.
As stated earlier, if you expect your yearly income to be less than $9,875, then your tax bracket will be 10%. So, you must calculate 10% of your weekly/biweekly pay and place the dollar amount into box 4c on your form W4.
After, your employer will remove this amount and put it towards your nonresident tax return. So, when your taxes is filed, your taxes would be paid.
If you need help filing your taxes or have questions, please contact our support team.