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FOREIGN EXCLUSION VERSUS FOREIGN TAX CREDIT

June 01, 2020

By Joshua Ashman, CPA & Nathan Mintz, Esq.

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Tale of the Tape: How to Choose Between the Foreign Earned Income Exclusion and the Foreign Tax Credit

For U.S. expats, avoiding the double taxation of income is a key expat tax basic concept. In most cases, this is accomplished by either utilizing the foreign earned income exclusion (FEIE) or the foreign tax credit (FTC).

But which method is better?

In this blog we demonstrate that while the foreign earned income exclusion is perhaps the more straightforward method (and may be the only option when foreign taxes aren’t paid), there are times when it may not actually be the best choice for U.S. expats.

Personal Eligibility Requirements

In terms of personal eligibility, the foreign tax credit rules are much less demanding than the FEIE rules.

In order to claim the foreign exclusion, you must satisfy a number of tests, namely that your tax home is outside the U.S. (which includes the requirement that you do not have an abode in the U.S.), and you satisfy either the “bona fide residence” test or the “physical presence” test. The bona fine residence test is passed if you reside in a foreign country for an uninterrupted period that includes the entire tax year. The physical presence test is passed if you are present in a foreign country for 330 full days during a period of 12 consecutive months.

In contrast, you do not need to pass any of these personal eligibility tests in order to claim the foreign tax credit.

Foreign Exclusion Versus Foreign Tax Credit for Parent Filers

When comparing foreign tax credit relief to the foreign earned income exclusion, the clear winner for expat parents is most often the foreign tax credit.

This is because taxpayers who utilize the FEIE cannot claim the additional child tax credit (the portion of the credit that exceeds your tax liability), which became refundable up to $1,400 per child under the Trump Tax Reform. This limitation does not apply, however, when the foreign tax credit is utilized.

Thus, assuming that your creditable foreign tax exceeds your U.S. tax, reducing your tax via foreign tax credit relief is the smarter choice.

Foreign Exclusion Versus Foreign Tax Credit for Retirement Savings

Foreign tax credit relief can also provide the better strategy in the case that a U.S. expat who maintains a U.S. retirement account, such as a traditional or Roth IRA. That is because income that is excluded as a result of the FEIE is considered income that cannot be contributed to an IRA.

For this reason, U.S. expats looking to save for retirement might find that foreign tax credit relief might yield more advantageous results than the FEIE. If you claim the foreign tax credit, you’ll have taxable wages to fund the IRA in the United States.

Claiming Both the Foreign Exclusion and Foreign Tax Credit

It should be noted that in some cases, it may be possible and preferable to claim both the foreign exclusion and the foreign tax credit.

This may be relevant, for instance, if the taxpayer’s income is higher than the FEIE maximum amount (for the 2019 tax year, the limit is $105,900), or if the taxpayer has passive income that does not qualify as earned income eligible for the FEIE.
Determining the best method can become a complex exercise, so an expat tax professional should be consulted to determine the optimal filing strategy.

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