Foreign earned income

What Is Foreign Earned Income?

Foreign earned income is money received for personal services performed in a foreign country by a U.S. citizen or resident alien. This type of income falls under the broad category of international taxation. It primarily includes wages, salaries, and professional fees, but generally excludes amounts received as a distribution of corporate earnings and profits or payments for services to the U.S. government. For individuals living and working abroad, understanding the specifics of foreign earned income is crucial for managing their U.S. tax obligations, as they may qualify for certain benefits like the Foreign Earned Income Exclusion or the foreign housing exclusion or deduction¹⁵. To qualify for these benefits, an individual's tax home must be in a foreign country, and they must meet either the bona fide residence test or the physical presence test¹⁴.

History and Origin

The concept of taxing U.S. citizens on their worldwide income, regardless of where they reside, is a foundational principle of the U.S. tax system, which is based on citizenship rather than residency for its citizens¹³. This contrasts with most other countries that employ a residency-based taxation system. To mitigate the burden of double taxation, where income might be taxed by both the foreign country and the U.S., provisions like the foreign earned income exclusion were introduced. These provisions are detailed in U.S. tax law, such as Internal Revenue Service (IRS) Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, which outlines special tax rules for Americans working overseas¹². Additionally, international tax treaty agreements, often guided by frameworks like the OECD Model Tax Convention on Income and on Capital, play a significant role in harmonizing tax laws between countries and preventing double taxation¹¹.

Key Takeaways

Foreign earned income refers to wages, salaries, or professional fees received for services performed outside the United States by U.S. citizens or resident aliens.
It does not include income from investments, pensions, or payments from the U.S. government.
To qualify for the Foreign Earned Income Exclusion, an individual must have a tax home in a foreign country and meet either the bona fide residence test or the physical presence test.
The exclusion amount is adjusted annually for inflation, allowing qualifying individuals to exclude a portion of their foreign earned income from U.S. taxable income.
Claiming the exclusion typically requires filing Form 2555 with the annual tax return.

Formula and Calculation

While there isn't a "formula" for foreign earned income itself, the primary calculation associated with it involves determining the amount of foreign earned income that can be excluded from U.S. gross income through the Foreign Earned Income Exclusion (FEIE). The maximum exclusion amount is adjusted for inflation each tax year.

To calculate the excludable amount, an individual first determines their total foreign earned income for the tax year. Then, they apply the maximum allowable exclusion. For example, for tax year 2025, the maximum exclusion amount is $130,000¹⁰. If a qualifying individual's foreign earned income exceeds this threshold, only the amount up to the limit can be excluded.

The calculation of the Foreign Earned Income Exclusion involves:

Determine Total Foreign Earned Income: This is the sum of all qualifying wages, salaries, and self-employment income earned for services performed in a foreign country.
Identify Maximum Exclusion Limit: This is the IRS-published limit for the specific tax year.
Apply Exclusion: The amount to be excluded is the lesser of your total foreign earned income or the maximum exclusion limit.

For instance, if a qualifying expatriate earns $150,000 in foreign earned income in 2025, they can exclude $130,000, and the remaining $20,000 would be subject to U.S. tax.

Interpreting Foreign Earned Income

Interpreting foreign earned income largely revolves around determining its eligibility for beneficial tax treatments, particularly the Foreign Earned Income Exclusion and the foreign housing exclusion/deduction. For U.S. citizens or resident aliens, all worldwide income is generally subject to U.S. tax. However, the designation of income as "foreign earned" is the first step toward potentially reducing one's U.S. tax burden.

To qualify for tax benefits related to foreign earned income, individuals must meet specific eligibility criteria: their tax home must be in a foreign country, and they must satisfy either the bona fide resident test or the physical presence test ⁹. The bona fide residence test requires the individual to be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. The physical presence test requires an individual to be physically present in a foreign country for at least 330 full days during any period of 12 consecutive months⁸. The successful application of these tests determines whether the income can be categorized as eligible foreign earned income for tax purposes, leading to potential exclusion from U.S. adjusted gross income.

Hypothetical Example

Consider Sarah, a U.S. citizen who moved to Spain for work on January 1, 2024. Her tax home is in Spain. She works as a software engineer and earns $140,000 in salary during the 2025 tax year. She meets the physical presence test, having been in Spain for more than 330 days during her 12-month period.

To determine her U.S. tax liability, Sarah will consider her foreign earned income:

Total Foreign Earned Income: $140,000 (salary earned in Spain).
FEIE Limit for 2025: $130,000.
Excluded Amount: Since her income is greater than the limit, she can exclude the maximum allowable amount of $130,000.
Taxable Foreign Earned Income: $140,000 (Total) - $130,000 (Excluded) = $10,000.

Sarah would report her $140,000 of foreign earned income on her U.S. tax return, then claim the $130,000 exclusion using Form 2555. This means only $10,000 of her foreign earned income would be subject to U.S. federal income tax, significantly reducing her U.S. tax liability. Any withholding or taxes paid to the Spanish government would be managed separately, potentially through a foreign tax credit.

Practical Applications

Foreign earned income primarily impacts the taxation and financial planning of U.S. citizens and resident aliens living and working abroad. Its practical applications include:

U.S. Tax Compliance for Expats: U.S. citizens and resident aliens are generally taxed on their worldwide income. Understanding what constitutes foreign earned income is the first step in determining eligibility for benefits like the Foreign Earned Income Exclusion, which allows qualifying individuals to exclude a certain amount of their foreign earnings from U.S. federal income tax⁷. This significantly simplifies their U.S. tax return filing by reducing their taxable income.
Minimizing Double Taxation: Along with the Foreign Tax Credit, the Foreign Earned Income Exclusion is a primary mechanism to prevent income from being taxed by both the foreign country where it was earned and the United States. This reduces the financial burden on individuals working internationally.
Financial Planning for Overseas Work: Individuals considering employment outside the U.S. must factor in the tax implications of foreign earned income. This includes understanding the specific requirements for the exclusion tests (bona fide residence or physical presence) and how they affect their overall financial well-being and decision-making regarding overseas assignments.

Limitations and Criticisms

While beneficial for many U.S. citizens and resident aliens working abroad, the concept and application of foreign earned income and its associated exclusion have limitations. One primary criticism stems from the U.S.'s unique citizenship-based taxation system, which requires all citizens, regardless of residency, to file U.S. tax returns on their worldwide income. This differs from the residency-based systems of most other countries⁶.

A key limitation is that the Foreign Earned Income Exclusion does not reduce self-employment taxes, only income tax⁵. This can lead to a higher tax burden for self-employed individuals working abroad compared to those who are employees. Furthermore, while the exclusion can reduce U.S. taxable income, it also affects the calculation of certain deductions and credits, which may be reduced or eliminated based on the excluded income. For instance, the Child Tax Credit can be limited if the Foreign Earned Income Exclusion is claimed. Some policy discussions have highlighted the complexities and potential inefficiencies of the U.S. international tax system for individuals, suggesting alternatives such as a move towards a pure residency-based tax system for U.S. citizens abroad⁴.

Foreign Earned Income vs. Foreign Tax Credit

Foreign earned income and foreign tax credit are both mechanisms designed to alleviate double taxation for U.S. citizens and resident aliens working abroad, but they operate differently and apply to distinct situations.

Foreign earned income refers specifically to the wages, salaries, or professional fees earned by an individual for personal services performed in a foreign country. The "Foreign Earned Income Exclusion" allows qualifying individuals to exclude a specific amount of this income from their U.S. taxable income. This reduces the amount of income subject to U.S. tax. It effectively makes a portion of the foreign income non-taxable by the U.S. government.

Conversely, the Foreign Tax Credit allows individuals to claim a credit against their U.S. tax liability for income taxes paid to a foreign government on foreign-source income. Instead of excluding the income, the credit reduces the U.S. tax bill dollar-for-dollar based on the foreign taxes already paid³. The Foreign Tax Credit is generally more beneficial for individuals who pay high foreign taxes (equal to or greater than U.S. taxes) or whose foreign earned income exceeds the exclusion limit. Individuals generally choose between claiming the Foreign Earned Income Exclusion or the Foreign Tax Credit, as they cannot typically claim both for the same income.

FAQs

Who qualifies for the Foreign Earned Income Exclusion?

To qualify for the Foreign Earned Income Exclusion, you must have your tax home in a foreign country and meet one of two tests: the bona fide residence test (being a resident of a foreign country for an uninterrupted period that includes an entire tax year) or the physical presence test (being physically present in a foreign country for at least 330 full days during any 12-month period)².

What types of income are considered foreign earned income?

Foreign earned income generally includes wages, salaries, professional fees, or other amounts received as compensation for personal services performed in a foreign country. It does not include amounts such as pensions, annuities, unearned income (like interest or dividends), or pay received as an employee of the U.S. government¹.

How do I claim the Foreign Earned Income Exclusion?

You typically claim the Foreign Earned Income Exclusion by filing Form 2555, Foreign Earned Income, with your annual U.S. federal tax return. This form helps you calculate the excludable amount and the foreign housing exclusion or deduction.