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Foreign earned income exclusion

What Is Foreign Earned Income Exclusion?

The Foreign Earned Income Exclusion (FEIE) is an Internal Revenue Service (IRS) provision that allows qualifying U.S. citizens or resident aliens living abroad to exclude a portion of their foreign earned income from U.S. federal income tax. This key aspect of international taxation aims to prevent double taxation on earnings for individuals who work and reside in foreign countries. By reducing the amount of income subject to U.S. taxes, the foreign earned income exclusion can significantly lower an individual's U.S. tax liability. U.S. citizens are generally taxed on their worldwide income, regardless of where it is earned, making provisions like the FEIE crucial for those living overseas.

History and Origin

The concept of mitigating double taxation for U.S. citizens working abroad has evolved over time. The foreign earned income exclusion, as part of U.S. tax law, was established to address the complexities faced by American individuals earning income in other countries while still subject to U.S. taxation. The IRS provides detailed guidance on this provision through various publications and forms, such as IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.5 This guide, updated annually, outlines the requirements and procedures for claiming the FEIE and related benefits.

Key Takeaways

  • The Foreign Earned Income Exclusion (FEIE) allows eligible U.S. citizens and resident aliens to exclude a specific amount of income earned while working in a foreign country from their U.S. taxable income.
  • To qualify, individuals must meet either the Bona Fide Residence Test or the Physical Presence Test, and their tax home must be in a foreign country.
  • The maximum exclusion amount is adjusted annually for inflation by the IRS.
  • The FEIE is claimed by filing Form 2555, Foreign Earned Income with a federal tax return.4
  • The FEIE can be combined with a foreign housing exclusion or deduction for qualified housing expenses incurred abroad.

Interpreting the Foreign Earned Income Exclusion

The foreign earned income exclusion is not a tax deduction but an exclusion, meaning the qualifying income is simply removed from the individual's gross income before calculating their U.S. tax liability. This distinction is important for understanding how it impacts overall tax obligations. For instance, if an individual earns above the exclusion limit, the remaining income is subject to U.S. taxes, but the excluded portion is not. Individuals must elect the FEIE and report their foreign earned income, even if it falls entirely within the exclusion limits.3 The IRS offers an Interactive Tax Assistant tool to help individuals determine their eligibility.

Hypothetical Example

Consider an eligible U.S. citizen named Sarah who lives and works in France for the entire tax year 2024. Her salary, considered foreign earned income, is $150,000. For 2024, the maximum foreign earned income exclusion is $126,500.

  1. Determine Qualified Income: Sarah's earned income from her job in France is $150,000.
  2. Apply Exclusion Limit: She can exclude up to $126,500 of this income.
  3. Calculate Taxable Income: $150,000 (Gross Foreign Income) - $126,500 (Foreign Earned Income Exclusion) = $23,500 (U.S. Taxable Income).

Sarah would then only be subject to U.S. federal income tax on $23,500 of her income, significantly reducing her U.S. tax burden. She would need to file Form 1040 and attach Form 2555 to claim the exclusion.

Practical Applications

The foreign earned income exclusion is a crucial tool in expat taxes and tax planning for U.S. citizens and resident aliens living abroad. It primarily applies to individuals who are employed or self-employed income in a foreign country.2 By reducing the amount of income subject to U.S. tax, it simplifies compliance and can eliminate the U.S. tax liability for many individuals whose foreign earnings fall below the annual exclusion limit. For those earning above the limit, it still provides substantial tax relief. This provision is detailed by the Internal Revenue Service, the federal agency responsible for tax collection and tax law enforcement.1

Limitations and Criticisms

While beneficial, the foreign earned income exclusion has limitations. It only applies to earned income (wages, salaries, professional fees) and does not cover passive income such as dividends, interest, or capital gains. Additionally, claiming the FEIE may prevent an individual from claiming certain deductions or credits that could otherwise reduce their U.S. tax liability, such as education credits or the child tax credit, as these may be limited by the excluded income. Furthermore, individuals who elect the FEIE cannot also claim the foreign tax credit on the income that is excluded. Careful tax planning is essential to determine whether the FEIE or the foreign tax credit offers the most advantageous outcome for a specific tax situation.

Foreign Earned Income Exclusion vs. Foreign Tax Credit

The Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC) are both provisions designed to alleviate double taxation for U.S. citizens and resident aliens living abroad, but they operate differently. The FEIE directly excludes a specified amount of foreign earned income from U.S. taxable income. In contrast, the FTC allows taxpayers to claim a dollar-for-dollar credit against their U.S. tax liability for income taxes paid to a foreign country.

Choosing between the two depends on individual circumstances. The FEIE is generally simpler and may be preferable for those whose foreign income is below the exclusion limit, effectively eliminating their U.S. tax obligation on that income. The FTC, however, might be more beneficial for individuals with foreign income significantly above the exclusion limit or those who pay high foreign taxes, as it can reduce U.S. taxes on all foreign-sourced income, not just earned income. It is not possible to claim both the FEIE and the FTC on the same income.

FAQs

Who qualifies for the Foreign Earned Income Exclusion?

To qualify for the Foreign Earned Income Exclusion, you must be a U.S. citizen or a resident alien and meet both a "tax home" test and either the Bona Fide Residence Test or the Physical Presence Test. Your "tax home" must be in a foreign country, and you must either be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year or be physically present in a foreign country for at least 330 full days during any 12-month period.

How do I claim the Foreign Earned Income Exclusion?

To claim the Foreign Earned Income Exclusion, you must file Form 2555, Foreign Earned Income, with your U.S. federal tax return (typically Form 1040). The form helps you calculate the excludable amount and any related housing exclusion or deduction.

Can I claim the Foreign Earned Income Exclusion and the Foreign Tax Credit?

You cannot claim both the Foreign Earned Income Exclusion and the Foreign Tax Credit on the same income. However, you may be able to use the Foreign Earned Income Exclusion for your earned income and the Foreign Tax Credit for other types of foreign-sourced income (like passive investment income) or for earned income exceeding the exclusion limit.

What types of income are covered by the exclusion?

The Foreign Earned Income Exclusion applies to "earned income," which includes wages, salaries, professional fees, or other amounts received as compensation for personal services performed in a foreign country. It generally does not apply to passive income, such as interest, dividends, capital gains, pensions, or annuities.

Does the exclusion amount change?

Yes, the maximum Foreign Earned Income Exclusion amount is adjusted annually for inflation by the IRS. It is important to check the current year's limits when preparing your tax return.