Last Updated 1 year ago
Imagine next April, when you’re earning $60,000 as a software tester in Tel Aviv. As you review your U.S. tax return, you notice a 39.6 percent tax rate next to a $1,000 dividend.
This top tax bracket is what President Trump has proposed for the 2025 reconciliation bill. The increase targets taxpayers earning above $2.5 million for single filers and $5 million for joint filers. However, many provisions in the international tax code automatically apply the highest annual rate to their calculations. As this threshold rises, these provisions can inadvertently affect the tax returns of Americans living abroad, even if they are nowhere near millionaire status.
Key Takeaways:
- President Trump’s proposed 2025 tax plan would raise the top U.S. tax rate to 39.6% for ultra-high-income earners, but certain international tax provisions could inadvertently apply this rate to Americans abroad with far lower incomes.
- Rules tied to Passive Foreign Investment Companies (PFICs) and foreign trusts automatically default to the highest U.S. tax rate.
- Distributing income from PFICs or trusts before the higher rate takes effect, and leveraging elections like the Qualified Electing Fund (QEF), can help mitigate unexpected tax hits.
- Careful tracking of foreign tax credits and running scenario analyses can minimize double taxation and clarify whether to distribute income now or defer it.
Why the Highest Rate Travels Down the Ladder
The Internal Revenue Code contains dozens of cross-references that read “highest rate under section 1.” Change that single rate, and a chain reaction starts. The impact is especially sharp for United States citizens who live abroad, hold foreign funds, or run overseas businesses, because several specialized rules default to the top bracket, no matter how small the actual income is.
Real-Life Examples
Passive Foreign Investment Companies (PFICs)
Israeli and European mutual funds often count as PFICs. The excess distribution method splits a payout across the years the shares are held, taxes each slice at the highest rate for its year, and then adds interest. Sarah earns $60,000. Her Israeli fund pays a $1,000 dividend in 2026. One slice touches 2025, so that part is taxed at 39.6% even though her bracket is only 22%. The tax on that slice more than doubles.
It helps to examine how PFICs are taxed to understand why this happens. The IRS does not just tax the dividend at your usual rate. Instead, it considers how long you held the investment, then retroactively applies the highest rate from each year. Even small dividends can attract large tax bills when high tax years are in the mix.
Foreign Trust Throwbacks
David, an English teacher in Haifa who earns $45,000, receives $5,000 from a Canadian family trust in 2027 after several years with no distributions. Form 4970* spreads the undistributed income over the missed years and taxes each part at the highest bracket for its year. Because 2025 is in the mix, every retroactive slice is taxed at 39.6%, and David owes tax as if he were a high-income earner.
This approach to trust distributions is particularly punishing because it treats the trust income as if it were earned each year it was not distributed. The throwback rule exists to prevent wealthy individuals from deferring income through trusts, but it can unfairly hit modest-income earners when the highest rate jumps during the deferral period.
Moves Expats Can Make Now
Identify at-risk assets
Make a list of your PFICs and foreign trusts. These are the most likely to be impacted by the proposed higher tax bracket, especially if they generate income that could be subject to the highest rate.
Plan income distribution timing
If possible, distribute PFIC or trust income in 2024 or early 2025. Doing so will lock in the current 37% rate before the proposed 39.6% rate takes effect, potentially saving on taxes.
Leverage elections strategically
If you hold PFICs, consider making a Qualified Electing Fund (QEF) election to spread income annually rather than accumulate it, avoiding the highest-rate hit. In the context of foreign trusts, review whether there are election options that could reduce the throwback tax impact.
Monitor tax credit opportunities
Foreign tax credits can offset U.S. tax liability but must be used in the same year the income is recognized. Keep careful records of foreign tax payments to match them with the appropriate year of PFIC or trust income to avoid paying tax twice.
Run scenario analyses
Model potential distributions from PFICs or foreign trusts to see how the proposed higher rate would impact your overall liability. Use this analysis to decide whether to take distributions now or wait.
The Practical Cost of Waiting
A rise of 2.6 percentage points may sound small until interest charges and state tax are added. The combined hit on a modest dividend or trust payout can equal a month of rent in Tel Aviv or a semester of school supplies. Planning now can mean paying 37 percent once, instead of 39.6 percent plus several years of compounded interest.
A tax targeted at millionaires can land on PFIC owners, trust beneficiaries, and small-company shareholders who do not feel wealthy at all. Spotting these pressure points today gives you room to plan before the law is final.
Further Reading from Philip Stein & Associates
- What Are Passive Foreign Investment Companies (PFICs)?
- Why Use a Trust?
- The Updated Process to Renounce U.S. Citizenship in 2025
Ready for a personalized strategy call? Reach out to Philip Stein and Associates so the millionaire tax does not surprise your modest income.