The Foreign Earned Income Exclusion is a powerful provision that every American living in another country needs to know about. Not only does it reduce your U.S. taxes, it can save you thousands of dollars in taxes that you aren’t legally required to pay!
On the surface, the Foreign Earned Income Exclusion looks pretty cut and dry. You (or, better still, your professional tax preparer) plug in the amount of earned income you made and then you’re off the hook to pay American taxes on those monies.
True, but like many regulations, there are caveats.
First, there is a limit on how much income you can exclude. For individual filers, that limit in 2021 is $108,700 per person, based on inflation. If you’re married and both live abroad and meet eligibility requirements, you can each select the Foreign Earned Income Exclusion to shield up to $217,400.
Second, you have to pass a test. Don’t worry, the test doesn’t require any study sessions or late-night cramming. Uncle Sam simply wants to make sure you actually live and spend the majority of your time abroad. That means you need to eligible though either bona fide residency test, establishing that you did indeed live outside the United States uninterrupted for the full calendar year, or the physical presence test, proving that you were physically outside of the U.S. for at least 330 full days during any consecutive 12-month period.
Third, you have to make a decision about which tax break works best: The Foreign Earned Income Exclusion or the Foreign Tax Credit. This decision depends entirely upon your own unique situation, so you may want to consult with a tax professional who specializes in expats to see which benefit is most advantageous.
Fourth, you cannot claim both on the same income, but never say never. It’s true that the Earned Income Exclusion and the Foreign Tax Credit cannot be applied to the same chunk of income. However, if you’re an expat who makes a substantial amount of income abroad, you may be able to use the Earned Income Exclusion for the first $108,700 then apply the Foreign Tax Credit to income over that amount.
Fifth, be familiar with the type of income you need to report to the IRS. After all, Uncle Sam isn’t just looking for his share of your worldwide wages and income. He’s also interested in tips, interest, dividends, pensions, rent, capital gains and royalties. All these sources must be reported even if you don’t receive a W-2 or 1099 statement from your foreign employer.
Finally, play by the rules. Familiarize yourself with the expat tax codes and file your Form 2555 to claim the Foreign Earned Income Exclusion on time to avoid possible penalties. In practise, this means filing it along with your Form 1040 by June 15, as expats receive an automatic two month filing extension. Income received in foreign currencies should be reported in U.S. dollars. If you feel overwhelmed, enlist help from a tax professional.