The Foreign Earned Income Exclusion is a great tax saving opportunity for Americans living abroad, allowing the exclusion of $104,100 in foreign earned income per person in 2018. Nice!
But… Of all the tax topics I’ve explored, the FEIE is among the most convoluted and obfuscated. For one thing, documentation uses words like convoluted and obfuscated. Worse, much of the information on the Internet is confusing or inaccurate.
It also isn’t necessarily obvious if a person should claim the FEIE, and doing so isn’t guaranteed to be advantageous.
In this post I attempt to explore the FEIE and when to use it, for ourselves and our posterity. (Well, ourselves at least… should we FEIE or nah?)
Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion allows a US Citizen or resident alien to exempt employment and self-employment income from US Taxation, even on income sourced from the United States and deposited into US bank accounts, as long as the Citizen / resident alien is outside US borders. If they qualify (details here.)
Income must be earned – income from dividends, capital gains, rental real estate, social security, or a pension cannot be excluded. Income also must be earned in a foreign country – work in International waters or in Antarctica or on the moon, etc… cannot be excluded. Nor can income from an overseas US government job. Essentially W2 and/or Schedule C income, or foreign equivalent.
For those of us who qualify and have foreign earned income… to FEIE or not to FEIE, that is the question.
Implications, Restrictions, & Reductions
Excluding income has implications, excluded income has restrictions, and numerous reductions mean it may not be possible to gain full value of the FEIE. It’s complicated, and excluding income could even result in a greater tax burden.
Some examples…
Implications
Refundable portion of Child Tax Credit (CTC) requires non-excluded Earned Income.
The Earned Income Tax Credit (EITC) is not available to anybody claiming the FEIE (and child must live with you in US 6+ months, so not necessarily applicable.)
Form 1116 becomes mandatory to claim Foreign Tax Credit. This likely means a reduction in FTC from withholding on International investments.
If income is from a business (not a job), the 30% rule and scaleback rule can significantly reduce benefit of FEIE.
Even though some income is excluded, ALL OTHER INCOME is taxed as if the exclusion doesn’t exist (at highest applicable marginal rate.)
Restrictions
Excluded income cannot be contributed to IRAs – you can’t both exclude a dollar and contribute it to a Roth IRA, for example.
Foreign tax paid on excluded income cannot also be deducted or credited via the Foreign Tax Credit. It’s one or the other.
Reductions
It isn’t possible to simply claim the full amount of the FEIE. Any income earned while on US soil cannot be excluded, meaning business trips to the US result in US (non-foreign) earned income.
Even though earned income is excluded, self-employment tax still applies unless you are covered by a totalization agreement.
An S-corp enables some income to be classified as a dividend instead of earned income, thereby reducing the amount of SE taxes. This dividend cannot be excluded with the FEIE.
Any deductions directly related to excluded income cannot be claimed. This includes business expenses, the deductible part of self-employment taxes, and the self-employed health insurance deduction. No double deductions.
Furthermore…
Electing the FEIE is not something you do independently each year. Once you claim the FEIE, you must continue to claim it in subsequent years if you have foreign earned income and qualify. You can formally revoke the election, but once revoked it cannot be used for another 5 years without permission from the IRS in the form of a Private Letter Ruling (User fees range from $200 to $28,300, and permission isn’t guaranteed.)
So some planning and foresight is involved…
Examples
In the following 3 examples I attempt to highlight the implications, restrictions, and reductions detailed above.
Small amounts of foreign earned income
A digital nomad family with 1 child earns $3,000/month working remotely for a US corporation, and files taxes as Married Filing Jointly. They work and travel around the world, and visit the US for business for 1 month, passing the PPT and avoiding a tax burden in any other country. There is no other income. Tax year – 2018
No FEIE | With FEIE |
---|---|
Total income: $36,000 ($33,000 Foreign) FEIE: $0 Standard deduction: $24,000 Taxable income: $12,000 Total tax: $1,200 Child Tax Credit: $2000 | Total income: $36000 FEIE: -$33000 Standard deduction: $24,000 Taxable: $0 Total tax: $0 Child Tax Credit: $75 |
Tax refund: $800 | Tax refund: $75 |
Roth IRAs: $11,000 | Roth IRAs: $3,000 |
Verdict: No FEIE (If in US, EITC = ~+$1,600) (Would qualify for nearly free health insurance under ACA) |
Notable:
- Income earned on US soil is non-excludable
- Child Tax Credit is effectively neutered with FEIE
- Roth IRA contributions capped at earned income
- Example: Our 2016 tax return where we did not claim the FEIE even though we qualified
Bonus taxes
Additional income of $1000 of non-qualified dividends sourced from an International fund like VSUX. Foreign tax of $150 withheld.
No FEIE:
US Tax on $1,000 = $100
Foreign Tax Credit: $150 (if total foreign tax is <$600, full credit allowed without Form 1116.)
Additional tax refund: $50
If FEIE, then must use Form 1116 to determine Foreign Tax Credit:
US Tax on $1,000 = $100
FTC reduced to $35 (remainder carried over)
Additional tax due: $65
Medium amounts of foreign earned income
Self employed couple has gross revenue of $104,000/year as bonafide residents of the Bahamas, a country with no income tax. Business expenses are $12,000. Other income includes $12,000/year in qualified dividends, and $12,000/year in rental real estate profits on a US property. Self-employed health insurance expenses are $1,000/month. They vacation in the US for 2 months every year to visit family.
No FEIE | FEIE |
---|---|
Income: Earned: $104,000 Rental: $12,000 Dividend: $12,000 Total: $128,000 | Income: Earned: $104,000 Rental: $12,000 Dividend: $12,000 Total: $128,000 |
Deductions: Business expenses: $12,000 Standard: $24,000 Health Insurance: $12,000 1/2 SE tax: $6,500 FEIE: $0 | Deductions: Business expenses: Standard: $24,000 Health insurance: $12,000 1/2 SE tax: $6,500 FEIE: $85,500 (Gross earned income - 1/2 SE tax - SEHI) |
Income Tax: $6,999 Marginal tax rate: 12% All QDs tax free. Can contribute $18,500 to solo 401k and $11,000 to IRAs (Traditional or Roth or both) | Income Tax: $0 Roth solo401k contributions: $18,500 IRA contributions: $0 (no earned income) |
Verdict: FEIE |
Notable:
- Rental real estate income is non-excludable and taxed as if FEIE didn’t exist
- Qualified dividends are taxed as if FEIE doesn’t exist
- No work performed on US soil (visit US only for vacation.) Bonafide resident doesn’t need to meet PPT.
- Deductions related to foreign earned income reduce amount of excludable income (no double deduction), e.g. 1/2 SE tax and self-employed health insurance
- Business expenses on excluded income are not deductible
- Excluded foreign income cannot be contributed to IRA, but CAN be contributed to solo 401k. (So says me and some guys’ (ex-)CPA.)
- Another example: Our 2017 tax return, coming SOON
Large amounts of foreign earned income
Self employed couple grosses $300,000/year as bonafide residents of a country with a flat tax of 20% on all income. They are equal partners in the business, with total expenses of $100,000. There is a totalization agreement so no SE taxes are required. They have no other income and spend no time in the US this year.
At first glance this looks like an ideal case for the FEIE. $200k profit split equally between 2 spouses, each claiming the FEIE, for total taxable income of $0.
Alas… this isn’t the case. The FEIE applies to gross rather than net income.
With an FEIE of $104,100 and gross income per person of $150,000, ~70% of gross income is excluded.
Since ~70% of income is not taxed, 70% of business expenses are not tax deductible
This leaves $45,900 of taxable income and $15,300 of deductions, for total taxable income of $30,600 each ($61,200 total.)
No FEIE | FEIE |
---|---|
Income: Gross: $300,000 Expenses: -$100,000 Net: $200,000 | Income: Gross: $300,000 Expenses: -$100,000 Net: $200,000 |
Deductions: Business expenses: $100,000 Standard: $24,000 FEIE: $0 | Deductions: Business expenses: Standard: $24,000 FEIE: $138,800 |
Taxable Income: $200,000 Foreign tax: $40,000 US Tax: FTC: $30,819 FTC Carry forward/back: $9,181 | Taxable income: $61,200 Foreign tax: $40,000 US Tax: $13,684 - FTC ($12,200) = $1,484 No FTC carry forward/back |
Verdict: No FEIE (FTC) |
Tax Math:
Foreign taxes paid: $300,000 – $100,000 = $200,000 * 20% = $40,000
Tax on AGI + FEIE ($200k) = $30,819
Tax on FEIE ($200k – $61.2k) = 138,800 * tax = $17,135
US tax = $30,819 – $17,135 = $13,684 (non-excluded income taxed as if FEIE doesn’t exist.)
Foreign Tax Credit can also be used as it relates to non-excluded income
Foreign Tax paid on excluded income = 138,800 / 200,000 = 69.5% * $40k foreign tax = $27,800
Foreign Tax paid on non-excluded income = 40,000 – 27,800 = $12,200
FTC = $12,200 max
US Tax remaining: $13,684 – $12,200 = $1,484 (make checks payable to US Treasury)
Without FEIE, the Foreign Tax Credit reduces US tax burden dollar for dollar of foreign tax paid
US tax burden on $200,000 net income = $30,819
Total US tax: $0
Remaining $9,181 can be carried forward or back onto future/past tax returns.
Notable:
- The Foreign Earned Income Exclusion applies to gross income.
- Expenses related to excluded income are non-deductible (scaleback rule)
- Excluded income cannot also benefit from Foreign Tax Credit
- The Foreign Tax Credit will likely be a better deal in countries with higher taxes than the US.
Final Thoughts
The Foreign Earned Income Exclusion has great potential, allowing the exclusion of $104,100 in foreign earned income per person in 2018.
However, it is highly nuanced with numerous implications, restrictions, and reductions. It will be highly beneficial to some expats and completely useless to others.
It’s been a long slow climb to figure this stuff out, perhaps because retirement has ruined my reading comprehension and critical thinking skills, but hopefully the examples above help others with the learning process. And… hopefully I got it all right :)
Addendum:
If you are interested in getting some tax assistance and/or wondering if the FEIE is right for you, the folks at Taxes for Expats have written useful online guides and have been helpful in answering my own questions from time to time. Click here for $25 off for GCC readers. (affiliate link)
NOTE: I’m just a random guy on the Internet who has no idea what he is doing. Tax laws change periodically, and you should consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice, is not a substitute for tax advice, and could just be wrong
S Corp K1 distribution can be excluded with the FEIE if the member is an active participant in the business.
Lots of people get this wrong. Even the CPA who sells expat stuff on your site.
Thanks John. Can you point me to some info to read further?
1) https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion-what-is-foreign-earned-income
Look at the ‘Variable Column”. The column headed Variable Income lists income that may fall into either the earned income category, the unearned income category, or partly into both. K-1 is ‘Business Profits” and falls under “Variable Column”.
2) https://www.irs.gov/instructions/i1120ssk#idm139909880685568
If you materially participated in the business, then your K-1 is active income (earned income).
3)
Earned income qualifies for FEIE
Thanks!
John, if you are getting notified of new comments… is there an email address we can use to discuss this further? (Plz contact me.) Thanks!
John, I read the regulation for Section 911, Reg. Sec. 1.911-3(b)(1), to specifically exclude distributions of earnings and profits from an S corporation:
The link: https://www.law.cornell.edu/cfr/text/26/1.911-3
The relevant sentence:
Earned income does not include any portion of an amount paid by a corporation which represents a distribution of earnings and profits rather than a reasonable allowance as compensation for personal services actually rendered to the corporation.
As much as I wish for this to be true, it looks like it’s wrong. From my research S-corp distributions are always going to be unearned income.
https://www.irs.gov/publications/p54#en_US_2018_publink100047456
Income from a corporation.
The salary you receive from a corporation is earned income only if it represents a reasonable allowance as compensation for work you do for the corporation. Any amount over what is considered a reasonable salary is unearned income.
Example 2.
You are a U.S. citizen and work full time as secretary-treasurer of your corporation. During the tax year you receive $100,000 as salary from the corporation. If $80,000 is a reasonable allowance as pay for the work you did, then $80,000 is earned income.
Also related: Distributions you receive as a shareholder of an S corporation do not constitute earned income for retirement plan purposes — from irs.gov
The FEIE is even less appealing once you thrown in Individual 401(k) contributions into the mix.
Hi Peter. Can you expand on that?
From the post: Excluded foreign income cannot be contributed to IRA, but CAN be contributed to solo 401k. (So says me and some guys’ (ex-)CPA.)
To my knowledge, whether or not you contribute to 401k has no bearing on FEIE because gross income is all that is considered.
Your article is right on GCC. For higher tax countries than US where your source income is based, it is a no brained to use FTC. This can shield some US tax liability but your unused tax credits will keep accumulating (expire after 10 years). A benefit of this is if you ever return back to US on paid employment, you can shield Federal taxes possibly for years (if your credits are over $100k) by using these credits every year till they are all used up. FTC has lot more benefits in some cases.
@Roman not sure you are correct. You can only use FTC on foreign income.
This post cites a response from the IRS saying that it’s not allowed: http://www.crevelingandcreveling.com/blog/expat-financial-planning-why-americans-should-consider-solo-401k
I also came across this post while researching. They reference a ruling from 1970. The 401k was created in 1978, and the Roth version in 2006.
I think more interesting is this:
See IRC Section 415(c)(3) Limitations on benefits and contribution under qualified plans
(a) Participant’s compensation = compensation from the employer
(b) special rules for self-employed individuals: income = participant’s earned income but determined without regard to any exclusion under section 911. (Section 911 is the portion of the IRC related to the FEIE.)
Our income should track fairly closely to your first example above, so I wont worry about it unless we end up making way more than we plan to in ER (entirely possible). Thanks for providing all of these details. Your tax related posts are always spot on.
That was the case for us in 2016. But in 2017 we made way more than we planned to make in ER.
FEIE is a lot more complicated than I thought. I’ll have to analyze it again when we live oversea. We probably won’t qualify because we won’t be out of the US the whole year. Mrs. RB40 will probably have to come back to check on her parent periodically.
If you are a bonafide resident of your new home, then travel to the US all you want
Hey Jeremy, your calculations seem correct to me.
Onw thing though, in your example with the 150 FTC. Why is there a 50 refund? FTC excess can generally be carried back a year or forward for 10.
The FTC would apply in full to existing tax burden, and the ACTC would increase by $50
Oh ok. Didn’t realize it was continuing the previous example.
One quick question: I am employed by a foreign university, thus not self employed. Can I still choose to “FEIE or not to FEIE”? For the last several years, I have taken the FEIE as I thought I did not have a choice. As a result, .I have not been able to contribute to my IRA. Can only self-employed individuals like yourself choose to take FEIE?
You can choose.
This is a case where Roth IRA is best. No point in stepping away from a 0% tax rate today to give yourself a future tax burden.
Yes, that makes sense….Thanks for the reply. One follow-up question: How do I claim my earned income? I mean, it’s not from a personal business and the university does not give me a year-end income statement like in the states. I don’t recall a category to claim it on the income tax form. Thanks!
Same place as you would report US earned income
Wouldn’t it be simpler and better if the USA went to residency-based taxation, like the rest of the world? (Yeah, yeah, except Eritrea). I struggle to see why the US requires its overseas citizens to be compliant in two conflicting tax systems– ??? What do you find to be the upsides of this system?
No one said this is a good system, it is just the current system.
Not that I believe that congress will change this in the forseeable future, but untill they do you still need to choose the best tax outcome for yourself.
Case study #4: permanent expat who has never worked/saved in the US and will likely not return to live or retire in the US earning less than $100k – FEIE all the way!!
Have you ever considered renouncing US citizenship?
Yes, but it always comes down to not wanting to create barriers to entering the US should I unexpectedly need to return to care for family for an extended period in the future. There are a few other considerations, but that’s the big one. Unless the whole of my nuclear family were to leave the US permanently (which could actually happen, but the likelihood is slim), I likely will keep the US citizenship and keep an eye on how I structure my financial life so I don’t need to pay any/much US tax in the future (at my current rate of progression, I’m going to have several years to figure out the optimal arrangement!). The next sticking point will be whether to pass on US citizenship to any kids I may have. I also have a few years to mull on that one too :)
Any good online CPAs you can recommend to consult with to determine what the optimal set up is for an online business paid in 1099s, New Zealand W-2ish income, and living 11/12 months in New Zealand?
Maybe check out Taxes for Expats. Links in the last paragraph.
I’m glad you wrote this up, Jeremy. We’re about to FIRE and are moving to Panama next summer. This is an important tax rule for us. I’m bringing in an expert to handle my taxes and tax planning during the transition, but it’s good to realize that FEIE isn’t just a gimme. We’ll have to figure out if it makes sense for us to use.
Can I ask – have you been able to leverage this for yourself and has it made a dramatic difference for you so far? I know the new tax laws in effect should make this year a little more interesting.
— Jim
We used the FEIE for 2017. The next post has all of the details.
If I have a self employed income of say 200k, I can use the amount that isn’t excluded in the FEIE towards my solo 401k? The same for doing a back-door Roth IRA? Not a resident of any country, as I don’t stay for more than 6 months a year in any place. Thanks.
Yes. Any non-excluded income can be contributed.
You say Qualified Dividends are taxed as if FEIE doesn’t exist. What does that mean exactly? If I am making $40, 000 USD abroad per year through employment but I earn $18, 000 through qualified dividends from assets annually, how will those qualified dividends be taxed? I see capital gains tax brackets show that if I make under $38, 600 in income I will pay 0% taxes on qualified dividends. Is my tax bracket for long term capital gains determined before or after my FEIE exclusion? I’d appreciate any help, thanks!
Pretend you are in the US. That is how QDs will be taxed
Wowzers. So if my total annual foreign income is less than $38, 6000, I will pay 0% taxes on qualified dividends per the capital gains tax bracket?
You also get a standard deduction. So about $50k potential tax-free income for a single filer
Awesome! Thanks for the verification Curry Cracker.
I don’t understand this: “(Gross earned income – 1/2 SE tax – SEHI)”.
I’m self-employed working abroad… so I plan on taking the FEIE this year and I’ll make about 95k in a foreign country for a USA employer (1099). If i take the FEIE what is the gross earned income as half of the SE tax?
Another question if anyone knows: I visited the USA for a month and worked 117 hours. From what I understand I can contribute that income to a Roth IRA. Do I need to deduct all taxes before I can contribute that amount? (Would be about 6k).
Will also have about 10k in div/rental profit.
You’ll exclude the full $95k, it will just be done in 2 chunks – a deduction for 1/2 of SE taxes and an exclusion of foreign earned income minus 1/2 of SE taxes.
The income earned on US soil is US income. It cannot be excluded and therefore can be contributed to a Roth.
Dividends and rental income cannot be excluded and will be taxed based on your total income as if you lived in the US (no FEIE.) The standard deduction will apply to this income.