When it comes to navigating the complexities of international taxation, understanding the distinctions between the Foreign Earned Income Exclusion (FEIE) and the foreign tax credit is crucial. These two mechanisms offer expatriates different options for minimizing their tax liabilities. In this article, we aim to provide you with essential information about FEIE and the foreign tax credit, helping you make an informed decision on which approach may be more suitable for your unique circumstances. Let’s delve into the key factors you need to know when considering FEIE and the foreign tax credit.
Overview of FEIE and Foreign Tax Credit
US Expats earning income overseas may be responsible for paying taxes in both their country of residence and the U.S. To alleviate double taxation, two options exist: the Foreign Earned Income Exclusion and the Foreign Tax Credit. This article will offer an explanation of each option to assist in determining the appropriate choice for one’s tax circumstances.
FEIE allows qualifying individuals to exclude a certain amount of their foreign income from their U.S. taxable income. On the other hand, FTC allows individuals to claim a dollar-for-dollar credit for foreign income taxes paid on their foreign-sourced income.
This credit can be claimed on Form 1116 and applied against U.S. tax liability. Unlike FEIE, there are no restrictions on the amount of foreign income that can be used to claim FTC. However, if the foreign tax rate is lower than the U.S. tax rate, individuals might benefit more from using FEIE.
When deciding between FEIE and FTC, it’s important to consider your individual tax situation. FEIE may be more beneficial for individuals who earn relatively low amounts of foreign income and meet the eligibility requirements. On the other hand, FTC may be more advantageous for individuals who earn higher amounts of foreign income and are subject to higher foreign tax rates.
What is the Foreign Earned Income Exclusion?
As a U.S. Expat with foreign income, you have the valuable option to leverage the Foreign Earned Income Exclusion (FEIE) to reduce your U.S. taxable income. The FEIE allows you to exclude a portion of your foreign-earned income. For the 2023 tax year, the maximum amount of income that can be excluded under FEIE is $120,000.
Who can claim Foreign Earned Income Exclusion?
First and foremost, you must have foreign earned income. This means income that you receive for services rendered while living and working abroad. This can include wages, salaries, bonuses, commissions, and self-employment income.
Other types of income, such as dividends, interest, and capital gains, do not qualify for the FEIE.
There are also specific rules and exclusions when it comes to housing expenses, such as rent, utilities, and repairs. If you have housing expenses that exceed a certain limit, you may be eligible for a housing exclusion in addition to the FEIE.
In addition, it’s important to keep in mind that the FEIE only applies to federal income tax. You may still be subject to other U.S. taxes, such as self-employment tax or state income tax, depending on your specific circumstances.
Overall, qualifying for the FEIE exclusion requires careful planning and attention to the specific requirements. If you meet the criteria, however, the FEIE can provide a significant tax break and make living and working abroad much more affordable.
Eligibility Criteria
The eligibility criteria for FEIE include meeting either the physical presence test or the bona fide residence test.
- the physical presence test requires you to have been physically present in a foreign country for a minimum of 330 days within a 12-month period.
- the bona fide residence test focuses on your residency status in a foreign country. To meet this test, you must establish yourself as a bona fide resident of a foreign country for an uninterrupted period that includes a complete tax year. This entails establishing a tax home in the foreign country and demonstrating an intention to reside there indefinitely.
What is the Foreign Tax Credit?
Foreign Tax Credit (FTC) is another option available to taxpayers who earn income abroad and are subject to taxes in both the foreign country where the income was earned and the United States. While it has its advantages, it also has some drawbacks to consider.
While FEIE may sound like a good deal, it’s important to weigh its advantages and disadvantages before making a decision.
| Foreign Earned Income Exclusion | Foreign Tax Credit | |
|---|---|---|
| Purpose | Exclude a certain amount of foreign earned income from U.S. taxation | Offset U.S. tax liability on income already taxed by a foreign country |
| Eligibility Criteria | Must meet either the Physical Presence Test or the Bona Fide Residence Test | Available to all U.S. taxpayers with foreign income |
| Qualified Income | Earned income (salary, wages, self-employment income) | Any type of income (earned or unearned) |
| Maximum Exclusion Amount | $120,000 (2023) for each qualifying individual | None |
| Reporting Requirements | Must file Form 2555 with the U.S. tax return | Must file Form 1116 with the U.S. tax return |
| Tax Benefit Calculation | Excludes the qualifying income from U.S. taxation, reducing taxable income | Provides a dollar-for-dollar credit for foreign taxes paid, reducing U.S. tax liability |
| Carryover of Unused Benefit | Unused exclusion cannot be carried forward to future years | Unused foreign tax credits can be carried back one year or carried forward up to 10 years |
| Additional Considerations | - If taxable income is eliminated using the FEIE, taxpayer may not have earned income and therefore cannot claim the refundable additional child tax credit of $1,400. - If taxable income is eliminated using the FEIE, taxpayer may not have earned income and therefore cannot make contributions to an IRA (Individual Retirement Account). | None |
| Potential Benefits | Helps lower taxable income, potentially reducing overall tax liability | Reduces double taxation by offsetting U.S. taxes on income already taxed by a foreign country |
Ultimately, the decision to use the FTC depends on an individual’s unique tax situation. While it can be a useful tool for offsetting U.S. tax liability on foreign income, it’s important to understand the potential drawbacks before making a decision.
Should I Choose the FEIE or the Foreign Tax Credit?
Here are some factors to consider:
1. Your income: The FEIE is most beneficial for individuals who have lower incomes. If your foreign earned income is below the maximum exclusion amount, you can potentially reduce your tax liability to zero.
2. Your tax rate: The FEIE is particularly useful if you live in a country with a lower tax rate than the United States or you don’t pay any tax on your income.
3. Your dependents: If your children are qualifying children, you might be eligible to claim the refundable additional child tax credit. You must have earned income i.e. claim the FTC instead of FEIE.
4. Your IRA deduction: You can only claim the IRA deduction if you have earned income. As such, you cannot exclude it with the FEIE, you should use FTC instead.
5. Your job: The FEIE may be ideal for individuals who work as independent contractors or freelance workers. These types of workers may have more control over their income and may be able to structure their work to meet the requirements of the FEIE tests.
In summary, the FEIE is a valuable tax benefit for individuals who meet the qualifying criteria. If you have lower foreign earned income, live in a country with a lower tax rate than the United States, and meet the FEIE tests, it may be the best option for you.
At 1040 Abroad, we understand the complexities of US tax obligations for expats and are committed to providing free tax advice to all US expats via email. Our team of expert accountants can guide you through the process and ensure that you stay compliant with all applicable tax laws. Don’t hesitate to reach out to us for help navigating your state tax obligations as a US expat living abroad.
