I always have a passion for tax. If you recall, I self-filed my tax in 2003 and 2004, and wrote a few dozen articles on various tax topics in this blog. Therefore, you probably cannot believe that I just filed my 2005 tax return only days ago.

If you follow this blog, 2005 is the year in which our tax situation got really messy: first, our business income really shot up during that year, and second, we moved from Seattle to Shanghai in late 2005, exposing us to tons of new tax rules.

Gladly, as part of the expatriation benefits, KPMG was hired to file tax for us for four years (tax year 2005 to 2008). Although I am fairly personal-finance-literate, I have to admit without KPMG running the show I will not be able to navigate the convoluted tax laws governing foreign residents.

Earlier in 2006, we were advised by our tax preparer KPMG to wait till January 2007 to file for the 2005 tax, so we can be entitled to some tax benefits with regard to foreign taxes. This month, KPMG notified us a tax return has been prepared, and we are due for almost $6,000 in refund! (In retrospect, the tax refund is probably due to the generous tax gross-up for some relocation benefits. In my accounting book, I was expecting to owe $500 in tax at the end of 2005.)

Apart from the temporal happiness of (re)gaining a sizable chunk of money, a study of the final return by the pros (a total of 45 pages) is actually a good learning experience. More importantly, I have two important findings that may affect how I manage our household finance in the future.

1. Our business income will be almost tax-free in the near future.

U.S. tax laws allow foreign tax credit that prevents a taxpayer with foreign residency from double taxing. Since income tax on salary income in China is much higher than that in the U.S., I almost don't have to pay any extra U.S. income tax on my China-based income. For 2005 when I only worked in China for a couple of months, I had accumulated a foreign tax credit carryover for almost $2,000 (read: the difference between higher China tax rate and lower U.S. rate, after applying maximum allowed foreign tax credit for tax year 2005).

When it comes to my business income, U.S. tax law says it is China-based income since I produced the income solely from working in China, even though all incomes are crediting to my U.S. bank account (and I was issued 1099-MISC forms every spring). What's better is I don't have to pay taxes on such income in China either since local tax authority considers it as earned outside of the country.

In summary, my job income will probably create a five-figure foreign tax credit every year that I cannot enjoy without extra non-job income. By recognizing my business income on my tax return, I will be able to apply these extra tax credits and effectively pay nothing extra on my business income. What a nice arrangement to ease my tax burden!

2. SE 401(k) contribution does not necessarily reduce my immediate tax by much.

In late 2006, I made a premature contribution to my Self Employed 401(k) account, in the belief I can reduce my immediate tax exposure. It actually didn't work out exactly as planned. By making a $3,000 contribution, my Adjusted Gross Income (AGI) dropped by the same amount, resulting in a tax gain of $840 (at 28% marginal tax rate). On the other hand, this move reduced my foreign tax credit by more than $500 (and therefore I'm entitled to $500 more in carryover to future years). In total, the immediate tax benefit for my $3,000 contribution is almost less than 10%.

In response to that, I will be more cautious in deciding my SE 401(k) contribution for the tax year 2006. I will calculate numbers in both ways and decide if and how much I should make my contribution.

Alas, the 2006 tax season is around the corner now! Will I be able to get some generous tax refund again?