Expats who live and work abroad need to pay US taxes on their earnings. However, the matter can be confusing since expats are also taxed by their country of residence. To ensure individuals are not taxed twice on the same income, the IRS allows expats to use the foreign earned income exclusion (FEIE). This valuable tax benefit can significantly reduce an expat’s US tax liability.
Who qualifies for foreign income exclusion? How do expats tell the IRS their income should be excluded? This guide will explain everything you need to know about foreign earned income and when to exclude it, helping you navigate the complexities of expat taxation and potentially save thousands of dollars.
What Is the Foreign Earned Income Exclusion?
The foreign earned income exclusion allows qualified American citizens and resident aliens living abroad to exclude a certain amount of their foreign earnings from US federal income tax. To claim the FEIE, you must have foreign earned income, your tax home must be in a foreign country, and you must meet either the bona fide residence test or the physical presence test. This exclusion applies to wages, salaries, professional fees, and other types of income you receive for personal services performed abroad.
The IRS adjusts the maximum exclusion amount annually for inflation. For the 2024 tax year, eligible individuals can exclude up to $126,500 of their foreign earned income. It’s important to note that the FEIE doesn’t apply automatically — you must actively claim it on your tax return using Form 2555.
Qualifying for the Foreign Earned Income Exclusion
To claim the foreign earned income exclusion, you must meet specific criteria set by the IRS. There are three main components to qualifying:
- Bona Fide Residence Test: You must be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. This test focuses on your intention to make a foreign country your home. Factors such as maintaining a permanent residence, participating in the local community, and paying local taxes can support your claim.
- Physical Presence Test: Alternatively, you can qualify by being physically present in a foreign country for at least 330 full days during any 12-month period. These days don’t need to be consecutive, but they must be complete 24-hour periods.
- Tax Home in a Foreign Country: Regardless of which test you meet, your tax home must be in a foreign country. Your tax home is generally your regular place of business or employment, regardless of where you maintain your family However, you can’t have an abode in the United States and still claim a foreign tax home.
Meeting these requirements allows you to exclude a portion of your foreign earned income from US taxation, potentially resulting in significant savings.
Maximum Foreign Earned Income Exclusion Amounts
For the current tax year, eligible individuals can exclude over $120,000 of their foreign earnings. This amount has increased gradually over time to account for rising costs of living.
If you qualify for the exclusion for only part of the tax year, you must prorate the maximum exclusion. To calculate this, multiply the maximum exclusion for the year by the number of qualifying days in the year, then divide by the total days in the year.
For married couples, if both spouses work abroad and meet the requirements, each can claim the exclusion separately, potentially doubling their tax savings.
What Income Qualifies for FEIE?
According to the IRS, eligible income types include wages, salaries, professional fees, commissions, bonuses, tips, and self-employment income. These must be earned from personal services performed in a foreign country.
However, not all foreign-sourced income qualifies for the FEIE.
Ineligible income types include pension or annuity payments, interest and dividends, capital gains, US government payments, income earned in international waters, and pay received after the end of the tax year following the year you performed the services. It’s crucial to understand that the FEIE only covers earned income from personal services performed in a foreign country. Passive income and certain other types of income don’t qualify, even if they’re from foreign sources.
Foreign Housing Exclusion
In addition to the FEIE, expats may also benefit from the foreign housing exclusion. This provision allows qualified individuals to exclude or deduct certain foreign housing costs from their US taxable income. This exclusion relates closely to the FEIE, as both aim to reduce the tax burden on Americans working abroad.
To calculate the foreign housing exclusion, you first determine your qualifying housing expenses. Then, subtract a base amount (calculated as a percentage of the FEIE limit) from these expenses. The result is your foreign housing exclusion, up to a maximum limit that varies by location.
What Is the Purpose of the Foreign Tax Credit Form?
To claim the foreign earned income exclusion, you must file Form 2555 with your US tax return. This form is designed to help you determine your FEIE and foreign housing exclusion or deduction.
Key sections of Form 2555 include:
- General information about your foreign residence
- Qualification tests (bona fide residence or physical presence)
- Calculation of your foreign earned income
- Determination of your FEIE amount
When dealing with Form 2555, be aware of common pitfalls. The IRS notes that failing to prorate the exclusion for partial year qualifications is a frequent mistake. Other errors include not reporting excluded income on Form 1040 and incorrectly calculating the foreign housing exclusion.
FEIE vs. Foreign Tax Credit
While the FEIE allows you to exclude foreign earned income, the Foreign Tax Credit (FTC) provides a credit for foreign taxes paid. The IRS states that you can’t claim both the FEIE and FTC on the same income, but you may be able to claim the FTC for taxes on income above the FEIE limit.
Choose the FEIE if you’re in a low-tax or no-tax country. However, if you’re paying higher taxes abroad than you would in the US, the FTC might be more beneficial. Always calculate your tax liability under both scenarios to determine the best option for your situation.
Need Help With Your Expat Taxes?
The foreign earned income exclusion offers significant benefits for US expats. Understanding its qualifications, limits, and filing procedures is essential for maximizing your tax advantages abroad.
Proper financial planning is crucial for expatriates. The intricacies of international regulations can be challenging to navigate alone. A professional specializing in expat finances can guide you through the FEIE, Foreign Housing Exclusion, and other relevant benefits. This expertise ensures you remain compliant with US tax laws while optimizing your financial strategy.
For personalized assistance, schedule a free consultation with our expat tax experts today. We’ll help you make the most of the foreign earned income exclusion and other expatriate tax benefits.