Foreign Earned Income Exclusion vs. Foreign Tax Credit

Foreign earned income exclusion

Section 911 excludes foreign earned income up to an annual inflation-adjusted limit, reported on Form 2555. The taxpayer needs a foreign tax home and must meet the bona fide residence test or the physical presence test of 330 full days in any 12-month period.

A housing exclusion or deduction may also apply. Excluded income still sets the rate applied to remaining income under a stacking rule.

Foreign tax credit

Section 901 gives a dollar-for-dollar credit for qualifying foreign income taxes, usually on Form 1116. Section 904 limits it by category, such as passive and general income. Unused amounts can generally carry back one year and forward ten years.

How to choose

The exclusion can suit someone in a low-tax country. The credit often suits someone in a high-tax country, and it can leave excess credits for later years. Dependents can matter too, because refundable credits may be affected by the exclusion.

The two cannot apply to the same income. Revoking the exclusion can also prevent reusing it for five years without IRS consent.

The tests for the exclusion in detail

Tax home is a person's main place of business or employment. A taxpayer does not have a foreign tax home for periods where their abode remains in the U.S. The bona fide residence test requires residence in a foreign country for an uninterrupted period including a full tax year. The physical presence test counts 330 full days in a 12-month period, and a full day runs from midnight to midnight.

The income must be earned for services performed abroad. Pensions, investment income, and pay from the U.S. government do not qualify. Self-employed people can use the exclusion against income tax, but it does not remove self-employment tax.

A side-by-side example

Consider a U.S. citizen earning $130,000 in a country with no income tax. The exclusion may remove all or most of that income from U.S. tax, because no foreign tax is available to credit.

Now consider the same person in a high-tax country, paying $40,000 of foreign tax. U.S. tax on that income might be about $25,000. The foreign tax credit could eliminate the U.S. tax, and the excess credit could carry over. The exclusion would have sheltered less, and it would not leave a carryover on excluded income.

Stacking, housing, and side effects

Under the stacking rule, tax on income above the exclusion is calculated as if the excluded income were still there. As a result, the remaining income is taxed at higher brackets. The housing exclusion or deduction covers some foreign housing costs above a base amount, with limits that depend on location.

Excluding income can reduce or remove the refundable portion of the child tax credit, because the exclusion lowers earned income for that credit. It also prevents IRA contributions based on excluded income. A taxpayer using the credit keeps more earned income in the calculation, which can be valuable for families.

Foreign tax credit mechanics

Foreign taxes must be income taxes, or taxes in lieu of income taxes, that the taxpayer legally owes. Value-added and property taxes do not qualify. The limit is the U.S. tax multiplied by foreign-source taxable income over total taxable income, calculated separately by category.

Taxpayers can elect to claim foreign taxes when accrued rather than paid, and that election then applies to later years. Small amounts of passive foreign tax may qualify for a simplified method without Form 1116.

Filing dates and common errors

U.S. citizens and residents living abroad generally get an automatic two-month extension to June 15, and can extend to October 15 with Form 4868. Form 2350 can give more time to meet the exclusion's tests.

Common errors include forgetting state tax, treating employer housing as excluded without checking, and missing FBAR or Form 8938. Totalization agreements, rather than these provisions, usually decide where social security tax is paid.

Frequently asked questions