For US expats, avoiding double taxation on worldwide income begins with understanding two pivotal IRS tax provisions: the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC). Evaluating the FEIE vs FTC is a critical task for US citizens living in a foreign country because how the provisions are applied directly impacts the efficacy of an expat tax return.
The reason for this is that each provision applies to income in distinct ways. So, parsing the nuances between FEIE and FTC allows individuals to strategically minimize their taxable income or more effectively engage with their expat financial advisors. In this article, we'll delve into both, equipping you with the knowledge to confidently approach filing your US tax return from abroad.
What is the Foreign Earned Income Exclusion (FEIE)?
The IRS Foreign Earned Income Exclusion (FEIE) is a residence-based tax provision that allows qualifying US taxpayers to exclude up to $120,000 in tax year 2023 (the return that will be filed in 2024). This figure is adjusted annually for inflation, so will increase for tax year 2024.
As its name suggests, the FEIE applies only to earned income. This qualifier means that this provision may only be applied to income earned, which includes wages, salaries, bonuses, commissions, and self-employment income.
Interesting callout: In certain cases, the application of the FEIE may reduce or eliminate student loan payments owed.
How to claim the Foreign Earned Income Exclusion (FEIE)
Typically, the FEIE is claimed by filing IRS Form 2555 in addition to Form 1040. If a US citizen is employed abroad with a US employer, it may be possible to claim an exemption from US income tax withholding on foreign-earned wages by filing Form 673. (1)
To qualify for the FEIE, there are two residence-based tests: the Bona Fide Residence Test and the Physical Presence Test. You must meet one of the tests to qualify.
Bona Fide Residence Test
To qualify for the FEIE via the Bona Fide Residence Test, expats must demonstrate they've established a permanent residence in a foreign country for an uninterrupted full calendar year. (2) Temporary absences for vacations or business do not break the continuity. The key tenant of this test is that one must have a clear intention of residing in that country for an extended and unspecified period, rather than for a brief assignment or specific purpose.
Physical Presence Test
As its name suggests, qualifying for the Physical Presence Test requires expats to prove they've been physically present in a foreign country for at least 330 full days within a consecutive 12-month period. (3) The 330 days do not need to be consecutive, and they can fall into parts of two calendar years. However, they must be full 24-hour days, and any days of transit, (i.e., you're just passing through a country), do not count.
Limitations of the Foreign Earned Income Exclusion
Determining which test is best to qualify for the FEIE can be a lengthy process, especially if you need to dig back into your travel records. Another consideration is that Form 2555 is a notoriously time-consuming form to fill out as it requires extensive information about an expat’s employment and work, resident address, time abroad, family members, and other details.
Another notable drawback of the FEIE is that it cannot be applied to passive income, including dividends, interest, and capital gains. Additionally, US taxpayers who claim the FEIE become ineligible to contribute to an IRA or 401(k) account or claim the Child Tax Credit (CTC). The reason in both cases is that the FEIE reduces the amount of earned income declared to the IRS to $0, thus, the taxpayer effectively prevents themselves from being able to execute financial actions requiring declared income to the IRS.
It’s also important to note that the successful application of the FEIE only absolves you of federal income tax liability. US taxpayers may still be subject to other US taxes, including state or self-employment taxes.
A final word of caution with the FEIE
If you claim the FEIE one year and then forgo it the next, you relinquish the ability to claim it for the next five years. For example, if you claimed the FEIE on your 2021 US tax return and then did not on your 2022 tax return, the soonest you would be able to resume claiming the FEIE would be on your 2026 tax return.
What is the Foreign Tax Credit (FTC)?
To claim the FTC, you will file IRS Form 1116. This tax provision is most useful when a US taxpayer resides abroad in a country with a higher income tax than the United States.
How the FTC works for U.S. Expats
The FTC works by reducing tax owed to the IRS by issuing a dollar-for-dollar credit based on taxes paid to a foreign country. There are no residency requirements needed to claim the FTC; the bar to claim it is essentially that you can prove that you have already paid tax on the income that the IRS would otherwise tax.
Essentially, to claim the FTC, you must be able to demonstrate that the tax:
- is a legal and actual foreign tax liability,
- was imposed on you,
- was paid or accrued, and
- was an income tax.
Notably, the FTC may be applied to both earned and passive income. Additionally, in instances where more foreign tax was paid than owed to the US, a US tax credit is created. This credit can be carried forward for up to 10 years or back one year. (5)
2023 update to the Foreign Tax Credit’s applications
In a landmark ruling in October 2023, the US Court of Federal Claims (Christensen v USA) determined that the FTC could be used to offset the Net Investment Income Tax (NIIT). (6) This ruling has particular implications for US citizens residing in France owing to the fact that the ruling is premised on an interpretation of the US-France Tax Treaty. However, it may also have positive tax and financial planning implications for the wider US expat community.
Limitations of the FTC
Just because you qualify for the FTC, it doesn’t necessarily mean it’s the best expat tax provision for you. Typically, the best tax circumstance to claim the FTC is when residing in a country with higher taxes than the US, such as Germany or Portugal. However, there are a few specific cases in which you are ineligible to take the FTC for foreign taxes paid.
Additionally, the FTC is nonrefundable, meaning that US expats will not receive an IRS payment for the difference between the US tax rate and their country of residence. (This is where the aforementioned US tax credit and its carryback or forward considerations come in.)
Key differences between the Foreign Earned Income Exclusion and Foreign Tax Credit
When determining which provision to claim, start by considering your country of residence. As noted above, the FEIE has more stringent residency requirements than the FTC, making it more time-consuming and, in some cases, challenging to claim. The FTC, on the other hand, essentially requires that you demonstrate the imposition of foreign income tax.
Although both the FEIE and the FTC allow US expats to reduce their US tax liability to zero, how each accomplishes that is very different, and the income tax rate in your country of residence will play a large role in determining which provision is best for you.
Strategic differences when each provision is applied to income
Historically, it has been in an expat’s best interest to claim the FEIE. However, the enactment of the Tax Increase Prevention and Reconciliation Act (TIPRA) in 2006 necessitated a recalibrated approach. (7) As a result, the FTC emerged as another option to offset US tax liability.
Expats should be aware that it is possible to claim both the FEIE and FTC, however, they cannot be applied to the same income.
Summing up the FEIE vs FTC: Which is best for you?
Below I break down a couple of examples of when the Foreign Earned Income Exclusion and Foreign Tax Credit may be a better fit. This is only intended to be educational and should not be construed as advice specific to your situation.
The Foreign Earned Income Exclusion may be a better fit for:
- U.S. taxpayers residing in countries with no income tax or lower income tax rates than the U.S.
- U.S. taxpayers with no qualifying dependents.
- U.S. taxpayers with student loan payments calculated based on their income.
- Independent contractors or freelancers who pay no foreign income taxes and are able to align their work schedules such that they meet at least one FEIE test.
- Americans living abroad who are unable or do not want to contribute to an IRA or 401(k).
The Foreign Tax Credit may be a better fit for:
- U.S. taxpayers residing in countries with higher income tax brackets than the U.S.
- U.S. taxpayers with qualifying dependents.
- U.S. taxpayers with unearned income.
- Americans who are self-employed in a country that requires them to register business operations in that country (e.g. Germany).
- U.S. citizens abroad who are able and want to contribute to an IRA or 401(k).
Understanding how certain tax provisions work is just the beginning
For high earners and high net-worth individuals, basic tax provision comparisons such as “FEIE vs FTC” are only a slice of the multitude of considerations that comprise an expat’s financial pie. To ensure that your financial planning accounts for all possible variables, we recommend working with a certified cross-border financial planner at Connected Financial Planning. As experts with personal expat experience, we ensure every financial decision is taken based on a practical, long-term outlook designed for sustainable growth, regardless of where in the world you go.
At Connected Financial Planning, we know that you work hard to ensure that you and your family are financially provided for the long term. We would love to support you in that endeavor –we're uniquely qualified to do so, thanks to our cross-border expertise and close client collaboration.
If you're a US expat looking to optimize your financial planning strategy for the long term, schedule a free consultation today.
Additional Resources & References:
- IRS Form 673 - Statement for Claiming Exemption from Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911
- FEIE - Bona Fide Resident Test
- FEIE - Physical Presence Test
- FTC - Eligibility Criteria
- Topic No. 856, Foreign Tax Credit | Internal Revenue Service (irs.gov)
- Court Rules that Foreign Tax Credits can be used to offset the Net Investment Income Tax (NIIT)
- Tax Increase Prevention and Reconciliation Act (TIPRA)