<#-- Rebranding: Header Logo--> <#-- Rebranding: Footer Logo-->

How to Reduce U.S. Taxes on Foreign Income

Most U.S. citizens and green card holders are taxed on worldwide income and subject to certain foreign assets reporting requirements as well. For your financial assets held outside the United States, there is not a lot you can do to reduce the burden of reporting besides transferring them to a U.S. account. However, for your foreign income the following steps may help you save some taxes associated with it.

The Foreign Earned Income Exclusion

Determine if you qualify for the foreign earned income exclusion (FEIE). In the tax year 2017, you can exclude up to $102,000 as an individual in foreign earned income for your federal income tax. The IRS spells out qualifications on its website. (For related reading, see: Understanding Taxation of Foreign Investments.)

To claim the foreign earned income exclusion, you must have foreign earned income, your tax home must be in a foreign country and you must be one of the following:

  • A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
  • A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.

  • A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

First, FEIE only applies to foreign earned income. Earned income includes wages, salaries and net earnings from self-employment. Interest, dividends, capital gains, pensions and Social Security from the government are not earned income.

Second, according to the IRS, “Your tax home is the general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home.” If you were assigned to another country or worked in another country for more than a year, you may claim that country as your tax home.

Last, you have to meet either the bona fide residence test, which is defined in the first two bullet points above or the physical presence test which is the third bullet point. The physical presence test is relatively straightforward. It is a common misunderstanding that one needs to have stayed in a foreign country for more than 330 days in the previous tax year. In fact, it only requires a consecutive 12-month period. For example, if you stayed in China from June 1, 2016, to July 1, 2017, you are eligible for the pro-rated exclusion amount for the year 2016 and 2017 based on the number of qualifying days in each year if you also meet all other requirements. (For more, see: Get a Tax Credit for Your Foreign Investments.)

The bona fide residence test is more flexible on the actual days you stay abroad, but it is more stringent on the purpose of your trip and the nature and length of your stay. For instance, vacation days in other countries are counted in the 330 days under the physical presence test. Under the bona fide residence test, you will fail the test if you take a vacation to China for a year. Another thing worth mentioning here is that “an uninterrupted period” doesn’t mean you cannot leave the country at all. You could still take temporary trips to other countries or even back to the U.S. for vacation or business as long as you show a clear intention of returning to the foreign country.

Form 2555 should be used to claim the FEIE. Under certain circumstances, you could use Form 2555-EZ instead. 

The Foreign Housing Exclusion and Deduction

If you are eligible for the foreign earned income exclusion you can also claim the foreign housing exclusion or deduction from your gross foreign earned income. The difference between the foreign housing exclusion exclusion and foreign housing deduction is that the exclusion only applies to the housing expenses provided by your employer and the deduction can only apply to the amount paid from self-employment income. Both the exclusion and deduction are subject to certain limitations and the actual amount will be calculated on Form 2555.

Comparing Which Saves More on Taxes

Make a comparison between the foreign earned income exclusion and the foreign tax credit to see which one can save you more on taxes. You can take either but not both. In most cases, a foreign tax credit, which helps to reduce your federal tax liability by the amount of foreign income taxes you paid dollar for dollar, is better than a foreign tax deduction, which only reduces your income rather than your taxes.

If you have paid or accrued income tax in a foreign country, you can claim the credit on Form 1116 for individuals or Form 1118 for corporations. Only foreign taxes paid on income such as wages, interest, dividends and royalties qualify for foreign tax credit.

Which option is better? First of all, you cannot take the foreign tax credit or deduction on the income you exclude under the foreign earned income exclusion or the foreign housing exclusion. However, you can still claim the credit on non-earned income like interest and dividends which are not covered under FEIE or any additional earned income on top of the FEIE limit.

For example, an individual who has foreign earned income over $102,000 in 2017 may use FEIE to exclude the first $102,000 and then take the credit for the rest. Secondly, for FEIE, use it or lose it. In contrast, the unused foreign tax credit can be carried back for one year or carried forward for 10 years. Lastly, when calculating your federal income tax, you need to figure out your income tax on your total income including the FEIE amount first. Then you can subtract the part of the tax on the FEIE amount. In other words, your marginal tax rate can easily start with 15%, or even 25%, based on your filing status and other deductions and exemptions.

From a tax perspective, assuming you are eligible for both FEIE and the foreign tax credit, you are better off using the credit if your foreign tax rate is higher than your U.S. tax rate. (For more, see: How Taxes for Retirement Accounts Abroad Work.)