DEFINITION of 'Foreign Earned Income Exclusion'

The amount of income earned from a foreign source that is excludable from domestic taxation. The foreign earned income exclusion can only be claimed by those who meet the foreign residence or physical presence tests, who have a tax home in a foreign country, and have foreign income.

Tax payers wishing to exclude foreign earned income must make an election to do so.

BREAKING DOWN 'Foreign Earned Income Exclusion'

During the 2007 tax year, the maximum foreign earned income exclusion was $85,700. If the election is made, the taxpayer must proactively elect to use this exclusion (on an moving-forward basis); this exclusion is not assigned automatically.

The exclusion is elected on Form 2555. Furthermore, taxpayers who claim this exclusion cannot deduct any business expenses incurred relative to the foreign income, make domestic retirement plan contributions of any kind that are based on this income or claim the foreign tax credit or deduction for any taxes paid to a foreign government on this income.

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