Hey GCC, the Foreign Earned Income Exclusion is amazing! Thank you so much for making me aware of this – I’m able to pay no tax on my entire earned income! I also saw on your blog that it is possible for a married couple to earn about $100,000 in qualified dividends and long-term capital gains. Can I do that too?! That is, since the FEIE excludes all of my overseas work income, can I also harvest $100k of capital gains tax free?! Cuz that would be sweet!`
I agree that would be sweet. But no. Mostly.
The FEIE and Capital Gain Harvesting
The Foreign Earned Income Exclusion, as the name indicates, allows the exclusion from taxation of foreign earned income. (More here.) This can result in incredibly low Adjusted Gross Incomes and Taxable Incomes.
For example, on our 2018 tax return, we had total income of over $135k but an AGI of ~$70k and Taxable Income of only ~$45k.
Using 2018 numbers, income from dividends and long-term capital gains isn’t taxed until total income is over $101,200 (MFJ.)
If our AGI is so low, the logic goes, then surely there is some opportunity to also harvest a bunch of tax-free capital gains. Yes?
Unfortunately, no.
How the FEIE excludes income
The FEIE isn’t nearly as generous as it looks upon first glance. To determine our actual tax burden with excluded foreign income, we must first find out exactly how much tax we would owe if we were living in the US or if the FEIE didn’t exist. Good bit of fun, that.
The FEIE then allows us to subtract the taxes due on a portion of our foreign earned income, the part that is already most favorably taxed.
All other / non-excluded income is taxed at our highest possible marginal rates.
With regards to the potential for harvesting long-term capital gains, if total income exceeds $101,200 (2018, MFJ) then any gains above that amount will be taxed at 15%+. It doesn’t matter than the FEIE results in reduced taxable income and adjusted gross income.
An example:
The good folks at engaging-data.com have a great visualizer for how different income segments are taxed, which I populated based on our 2018 tax return.
As depicted in the top income segment CG15%, if we were in the US, $27,123 of our capital gain income would be taxed at 15%, with a tax burden of $4,068. (Which matches our 2018 1040 Line 11.)
More capital gain income would also be taxed at 15%.
Only after this is determined does the FEIE apply, excluding the foreign earned income.
In 2018, we excluded $57,775. Mathematically speaking, the FEIE filled the entire 10% bracket (19,050 * 10%) and much of the 12% bracket ($38,725 * 12%.) for a total of $6,552. (Doesn’t match the graphic above.)
This leaves only the tax on the capital gains, which are unfortunately not $0.
Summary
The FEIE can result in significant reductions in taxable income and adjusted gross income. This leads many to assume expats have the opportunity for the harvesting of large capital gains.
Alas, taxes on all non-excluded income are calculated as if we were residing in the US / the FEIE didn’t exist. Only then are the relevant taxes on foreign earned income subtracted from the total. In effect, the non-excluded income is taxed at the highest applicable marginal rates.
If total income is less than $101,200 in 2018 (MFJ, single filers divide by 2) then expats can harvest up to that threshold, but any qualified dividends or long-term applicable gains above this threshold will be taxed at 15%+.
“Fun” fact, up until 2006 the exclusion actually did enable you to do this. Then the IRS caught on :)
Yup. The good old days.
How did you learn about these tax strategies you have begun posting? Was it studying books or working with an accountant or digging into tax laws or something else? I appreciate your write ups that fit your experience and I’ve certainly learned a lot from you and Mad FIentist, but I’m curious where the learning came from if I ever get an itch to scratch to learn more about what’s out there that may fit my situation that neither of you have had a reason to look into (I don’t have a particular question in question, it’s the you don’t know what you don’t know question).
Just through doing my taxes. Ultimately by reading the IRS documentation and training info for their auditors.
I’d love to know where to find that training info! Maybe a post on “how to audit your own tax return”. I’ve mentioned the FEIE to my sister who works remotely teaching Chinese kids English online and wants to relocate to Asia anyway. She’s totally on board, so thanks for the solid advice!
Here is a link to the IRS practice unit for the FEIE (pdf). It’s dry, with numerous references to the tax code in all its glory.
Most people would likely be better off aiming to understand just 20% of the info, or finding a site that puts tax concepts into human language with a bit of tongue-in-cheek humor. If such a thing exists.
In this case, it seems.most advantageous to use the standard deduction as the limit on capital gains harvesting, assuming the FEIE isn’t all uses, correct?
The standard deduction and 0% space up to $77,200 MFJ, total $101,200.
The MFJ FEIE for 2018 is $103,900
FEIE for individuals in 2018 was $103,900. Each person can claim it.
The tax-free qualified dividend / long-term capital gain space in 2018 was $101,200, $24,000 from standard deduction and $77,200 of 0% qd/ltcg bracket.
I see. That makes sense. So FEIE isn’t that beneficial if you have large capital gains every year.
It excludes the earned income saving us $6k last year. But excluding doesn’t mean the income didn’t exist.
Do you also get taxed at the foreign country you reside in? How does that work?and what about double taxation?
Thanks
Depends on where you live. Many countries don’t have an income tax at all, or don’t tax overseas income.
If you do pay income tax to a non-US government, then you have the option of using the Foreign Tax Credit instead of the FEIE.
I love the Sankey chart for tax rates – that led me to the engaging-data website which is a real gem! So thanks for that.
When I talk to fellow expat colleagues (who mostly are from euroland) it is just astounding their reaction to the US tax rules regarding expats and their earnings. Most all of these guys exclude 100% of their earnings since they reside outside their respective homelands >180 days each year. At some point in the conversation the statistic showing the cohort countries taxing their expats in similar manner as the US. I believe at this time that is still Sierra Leone and Myanmar. Quite a cohort.
I tried to tease out my question by reading your post and the comments but I am still not quite clear regarding my situation and wanted to ask it here:
Scenario-
Gross Income: 62k
Tax Filing: FEIE (Single, no dependents)
Given my income is less than 101k, if my capital gain are below that for my total income is my tax liability on those capital gains 0%? Or is my capital gains lability based off my AGI as if my the FEIE didn’t exist.
Thanks!
Hi Sam
The $101,200 mentioned in this article is for a married couple filing jointly (MFJ.) Single filers need to divide that by 2 ($50,600.) This is from the Standard Deduction ($12k in 2018) and the 0% tax bracket for qualified dividends / long-term capital gains ($38,600 in 2018.) The numbers are roughly 2% higher for 2019.
Always taxes on non-excluded income are calculated as if you are in the US / the FEIE didn’t exist.
Since your total income is higher than $50,600, you won’t be able to harvest any additional capital gains tax-free, even though all of your foreign earned income could be excluded.
Bummer, there goes that option. I thank you for your quick response. The pickle I am in is that I am making and saving a good amount working abroad as my cost of living is so low. However given my domiciled State has a flat tax and doesn’t recognize the foreign earned income tax credit, I am pretty much stuck with filing under the FEIE, which would then bar me from investing in my Roth IRA, and Traditional IRA I had when I worked in the US. I really don’t feel like going through the hassle of filing more paperwork to have my domicile to Florida which does not have an income tax to allow me more investment options, but I can’t seem to think of any other choices. Well, other than just saving a large lump sum and just by property of course, but I would like to have some other forms of investments as well with less tax liability. I’m all ears if you have any other suggestions.
I would do the paperwork.
I would also be careful not to let the tax tail wag the dog. Seldom does it make sense to NOT invest in something just because of taxes.
Hi,
I’m in a similar situation with Sam and I’m trying to find out my options. In an article published by Greenback Tax Services titled “FIRE for US Expats: How to Make Smart Money Moves”, they lay out an example in which someone filing MFS with a foreign income of $100,000 can use the FEIE to exclude all of their foreign income, then use the standard deduction to exclude up to $12,000 (as of 2019) of capital gains. I understand your explanation in this comment, but it seems to be at odds with the article below. Am I missing something?
https://www.greenbacktaxservices.com/blog/fire-for-us-expats-how-to-make-smart-money-moves/
Thanks for all your great content.
Both articles say the same thing – you can do both, but you don’t get $100k FEIE AND $100k tax-free long-term capital gains. You get ~$100k total, split between the two.
The tax return linked in the above article shows a detailed example.
Thanks for the fast reply. Just to clarify, the Greenback Tax Service article is saying that the following is allowed:
Foreign income from salary: $100,000
Capital gains from US investments: $12,000
I can exclude $100,000 with the FEIE and $12,000 with the standard deduction for a total of $112,000 tax-free, but I can’t have more than the $12,000 tax-free capital gains because that surpasses the limit of the FEIE + standard deduction.
Stated simply, you get an exclusion (FEIE) and a standard deduction. Both result in zero tax on that income.
Great site and explanation! Just one question – how does this work if I use the Foreign Tax Credit in lieu of the Foreign Earned Income Exclusion?
For instance, let’s say I make 100k and pay 25k in taxes to the foreign European government in income taxes (which is over the amount of federal taxes I’d pay at that salary in the US). I would have a “negative” amount of taxable income due to the credit.
If I then accrue reportable capital gains and dividends over that same tax year (from a US-based investment portfolio), would this “US income” be taxed at 0% or, would they be calculated at the normal rate as if I had never applied the Foreign Tax Credit (i.e. 15% effective rate)? Thanks! :)
15%+.
Tax calculated on the total, credit applied afterwards and limited on Form 1116 so earned income taxes don’t offset investment income taxes. Negative amounts carried forward up to 10 years.
Hi! Thank you for this – I just want to make sure I understand, so apologies for the repetition.
In effect, when calculating taxable income for the purposes of figuring out “how much of your 0% capital gains tax window is left”, add back the earned income you excluded under the FEIE, even though ‘taxable income’ as listed on line 15 of your 1040 does not include said income – but other deductions do factor in.
So, for example, if earned income for a couple filing jointly is 60,000 of which all can be excluded under the FEIE such that taxable income as listed on line 15 of the 1040 is 0, the couple nonetheless cannot make 80,800 of tax free capital gains (the 2021 max for the 0% bracket). The filers in this scenario only get 45,900 capital gains at 0% because their taxable income for the purposes of calculating capital gains tax is not 0 but rather 34,900 calculated as 60,000 (entire earned income without consideration of FEIE) – 25,100 (assuming only standard deduction for married filing jointly].
Is that accurate? If so, is there an IRS source for this? Thanks a lot!
Mostly accurate – the standard deduction and the FEIE are mutually exclusive, it is important to think of them separately. The reason being: the standard deduction zeroes out income of any type (US earned, short term capital gains, non-qualified dividends, Roth conversions, etc…)
So… you have:
Standard deduction: 0% tax rate on any income type
FEIE: 0% tax rate on your $60k foreign earned income
LTCG/QDs: 0% tax rate on $80,100 – $60k of long-term capital gains or qualified dividends
As an IRS source, go through the instructions and calculations for Form 2555. It will have you fill out the Schedule D capital gains tax worksheet and/or the long-term capital gains and qualified dividends tax worksheet.
This article is actually very inaccurate. FEIE Only applies to earned income. Capital gains, dividends, and interest are not earned income and you get NO benefit from living internationally…you must pay tax on ALL of it!
Please read the article before commenting.