Foreign Earned Income Exclusion or Foreign Tax Credit?

Feb 12 2016

As a U.S. citizen residing and working abroad you are subject to taxation in both the country of your residence and the United States.  The U.S. is the only developed country in the world to tax its citizens regardless of residency.  This means you are subject to taxation in the U.S. on your WORLDWIDE income, regardless of where you live. 

There are several mechanisms in place to avoid “double taxation” between the U.S. and your resident country.  This article will take a look at the foreign earned income exclusion and foreign tax credit.  It is important to fully understand both the foreign earned income exclusion and the foreign tax credit before deciding how to proceed.

Foreign Earned Income Exclusion (FEIE)

IRC §911 allows for the exclusion of up to $105,900 (for 2019, adjusted annually) of foreign earned income per taxpayer.  In addition, you can exclude or deduct certain foreign housing amounts.  Some key points to consider with the FEIE:

  • It is a voluntary ELECTION.  This means you have to file a tax return with Form 2555 or 2555-EZ to elect the exclusion.  You still have a tax return filing requirement even if you earn less than the exclusion amount.  A lot of people confuse this point.
  • The election must be initially elected on a timely filed return or on a late-filed return filed within 1 year from the original due date of the return. form 255; foreign earned income exclusion
  • Once you choose to exclude foreign earned income, that choice remains in effect for that year and all later years unless you revoke it.
  • Once you revoke the FEIE, you cannot claim it again for five tax years.
  • The exclusion applies only to EARNED income.  Therefore, pension payments, social security benefits, interest, dividends and other PASSIVE incomes are not excludable.
  • If you earn in excess of the FEIE, you will be taxed on the excess income.  Foreign tax credit, may be available to offset U.S. tax.  However, sometimes using both FEIE and FTC can result in a higher U.S. tax than just using FTC.
  • The exclusion is an above-the-line deduction, meaning Adjusted Gross Income is reduced (to zero for a full exclusion of income).  Many tax credits and deductions are based off of a modified-AGI.  Therefore, you likely will not be eligible for them if your AGI is zero.  See the discussion below.
  • FEIE is the preferred choice if you reside in a country that does not have an income tax or that has a lower tax rate than the U.S.

Foreign Tax Credit (FTC)

IRC §901 allows for a dollar-for-dollar reduction in your U.S. income tax for income taxes paid to a foreign country on the same income.  Some key points to consider with FTC:

  • Foreign tax credit does not require an election.  Foreign tax is reported on Form 1116.  If the foreign taxes paid exceed your U.S. liability on that same income, you generally can carryback (1 year) or carryforward (10 years) the excess tax credit to another tax year.
  • If you elect to have all or a portion of your foreign earned income excluded, then all or a portion of your foreign tax credit related to this income is disallowed.
  • Foreign tax credit can be taken for all types of income.  Foreign taxes are categorized into “baskets.”  You must figure the foreign tax credit for each separate basket.  Tax credits from one basket cannot be used to offset income from another basket. The baskets are: general, passive, sanctioned income (§901(j)), certain income re-sourced by treaty, and certain lump sum distributions from an employee benefit plan.
  • Because foreign tax credit is a dollar-for-dollar credit against U.S. tax, your AGI and modified-AGI are not adjusted.  This means you are eligible for tax credits and deductions, as discussed below.
  • FTC is likely the preferred choice if you reside in a country that has higher tax rate than the U.S.   In most cases, if the foreign tax rate is higher than the U.S. tax rate, there will be no U.S. tax on the foreign income. 
  • You do not have to worry about meeting the Bona-Fide Resident test or the Physical Presence Test.

Why does it matter?

As stated above, most tax benefits and credits are based on AGI.  If you have an AGI of $0, you miss out on these potential benefits: 
  • IRA contributions- If the FEIE fully excludes your earned income, you will not be eligible for IRA contributions (including ROTH IRAs).  Income excluded under FEIE is specifically excluded from the taxable compensation definition for IRA contributions.
  • Child Tax Credit and Additional (Refundable) Child Tax Credit- The child tax credit is up to $1,000 per child.  if you have no tax due, because all your income has been excluded, you lose this credit.  The Additional Child Tax Credit is a refundable credit, meaning you may get up to $1,000 per child refunded to you.  But, this credit is specifically not allowed if you claim FEIE to reduce your taxable income to $0.

Many expats assume that excluding income is the best option, not fully understanding how foreign tax credits work.  It is important to analyze the income, foreign tax and U.S. tax implications of both the FEIE and FTC options before making a decision. 

What do I do now?

If you are unsure of which method to use to avoid double taxation, contact us today for a free consultation.

©2017 SDC, LLC
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult tax, legal and accounting advisors before engaging in any transaction.

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