Foreign Earned Income Exclusion Vs Foreign Tax Credit

Foreign Earned Income
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Updated for 2019

Foreign Earned Income Exclusion (FEIE) in Brief:

As a U.S. citizen or resident alien living abroad, you are taxed on your total income which includes your foreign earned income. Under FEIE you are allowed to exclude up to a certain amount* (limit is $105,900 for 2019) of your foreign earned income from your tax returns, thus reducing your taxable amount. Individuals must meet one of two types of tests namely, Bona Fide Residence Test and Physical Presence Test in order to qualify for foreign earned income exclusion.

*This amount is indexed to inflation

Other deductible expenses under FEIE:

  • Those qualifying for FEIE under certain circumstances can also avail Foreign Housing deductions that allow you to exclude taxable foreign housing expenses

  • Your meals and lodging expenses borne by your employer can also be excluded (Availing this may in some cases offset your earned income exclusion)

Note: Exclusion applies only to foreign earned income NOT including pension/annuity payments or payments received as a U.S government employee.

Which form to file?

Form 2555 and Form 2555-EZ along with Form 1040/1040X

More information on FEIE is detailed in Publication 54 

Foreign Tax Credits (FTC) in Brief:

As a US citizen or resident alien who

  • is required to pay (or) has paid taxes on their income to a foreign country or US possession and

  • has US tax liability on the same income

 You are allowed to avail appropriate tax credits to offset that US tax liability. This is to alleviate you from the burden of double taxation from both the US and the foreign country you pay taxes to.

Note: Your foreign taxes are eligible for tax credits ONLY if it is

  • a legal and actual* foreign tax

  • a tax you are required to pay (or) have paid to the foreign country/US possession

  • levied on you by the foreign government/US possession

  • income tax

*”actual” here refers to total foreign tax amount minus any refundable tax amounts provided by the foreign government or US possession)

How much FTC can I claim? The foreign tax credits that can be claimed is (a) equivalent to foreign tax paid or accrued or, if lesser, (b) Credit limit.

Credit Limit calculation:

Your credit limit = US tax liability x Total taxable income – Foreign + US

Which form to file?

In order to claim your tax credits, as an (a) individual you must file Form 1116 and as a (b) Corporation you must file Form 1118. In special cases however, you may be exempt from filing Form 1116 for this purpose.

More information about FTC is detailed in Publication 514

Which should I opt for? FEIE or FTC?

This question has no definite answer. It is dependent on your circumstances during election. Therefore, here are highlights that outline what is the preferred election in each scenario:

Can elect FEIE

  • As an employee expecting to work in a country with no employment tax or lower tax rate than the U.S.

  • Involved in a profitable trade/business in a foreign country that has no corporation/business tax or has a lower tax rate than the U.S.

  • In some cases, if foreign housing costs are covered by the employer.

Can elect FTC

  • If you live in a foreign country with higher taxes than the US. eg., US citizens living in Canada or most European countries

  • If it is your first year residence in foreign country and you cannot pass the Bonafide Residency test and opt for FEIE.

  • If you reside in a country with low or absent taxes. eg. Dubai. Here, opting FEIE is definitely advantageous compared to FTC.

Note: In addition,

Process of FTC claiming is easier.

You may use Form 2555 and Form 1116 on the same return, but cannot use the same earnings (and taxes paid relating to those earnings) on both the forms. For example, if your foreign earned income is $119,600, you can only exclude foreign earned income up to $105,900 on the Form 2555 which will reduce your taxable income on the return. The remaining foreign earned income of $13,700 may be used on Form 1116. You would need to determine which amount of the foreign taxes paid is allocated to the $13,700 and only use this portion of the foreign taxes in the calculations on Form 1116. On the other hand, if you would like to claim a foreign tax deduction instead of the foreign tax credit, then you would use Schedule A instead of Form 1116.

Based on the above pointers, there are definitely more situations where claiming FTC is more beneficial but then again, depends on which of these above categories you fall under.

Also read The Delay of Tax Refunds in 20172018 Expats Tax Due DatesInternational Tax Foreign Earned Income Exclusion Form 2555 and Report of Foreign Bank and Financial Accounts (FBAR)

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