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.
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.)
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.
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.
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…
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)|
Standard deduction: $24,000
Taxable income: $12,000
Total tax: $1,200
Child Tax Credit: $2000
|Total income: $36000|
Standard deduction: $24,000
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)
- 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
Additional income of $1000 of non-qualified dividends sourced from an International fund like VSUX. Foreign tax of $150 withheld.
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.
Business expenses: $12,000
Health Insurance: $12,000
1/2 SE tax: $6,500
Health insurance: $12,000
1/2 SE tax: $6,500
(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)
- 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.)
Business expenses: $100,000
|Taxable Income: $200,000|
Foreign tax: $40,000
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)|
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.
- 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.
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 :)
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