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Foreign Earned Income Exclusion- A common misconception

Are you an American citizen living abroad? Have you heard that if you make less than ~$98,000 of (non-US) wages or self-employed income that you do not need to file a US tax return? Have you heard about an exclusion that allows you reduce your taxable income for US tax purposes but have heard multiple different interpretations of how it actually works? Are you under the impression that you don’t need to file a US tax return because you have less than $98,000 and live outside of the US?

The foreign earned income exclusion is a well known deduction but can often be misunderstood by US taxpayers living and working outside of the United States.

Foreign Income exclusion form 2555

What is the foreign earned income exclusion?

The foreign earned income exclusion allows taxpayers to deduct a maximum amount of up to $97,600 (2013) of foreign (earned) income, including wages, bonuses and self-employed income to reduce their taxable income. The exclusion amount is adjusted annually for inflation. In 2014, the amount is $99,200.

Can all foreign income be excluded?

No. Only certain “earned income” can be excluded. As a result, income such as pension and investment income (interest, dividends and capital gains) cannot be excluded.

When can I use it?

You can file form 2555 annually to claim the foreign earned income exclusion; however, there are restrictions on use if you begin to use the deduction one year and choose to revoke the election (ie not claim it) in a future year. As a result, it’s often worthwhile assessing whether you are any better off claiming the exclusion and if there will be any implications to claiming it/ revoking the claim in future years.

Why do I need to file a US tax return if I qualify for the Foreign Earned Income Exclusion?

A US tax return must be filed as you are not entitled to the deduction unless you claim it by filing the required form 2555 with your 1040 return.

This sounds great. Are there any downsides to using it?

Apart from the restrictions mentioned above if you ever choose to claim the earned income exclusion and then revoke it, there are also a few other things to keep in mind. The first being that assuming you still have taxable income after you make the foreign earned income exclusion, this income will all be taxed at the higher marginal rate as if you had not excluded any of your income. This may cause issues for those claiming foreign tax credits. Another factor being that without claiming the foreign earned income exclusion, you would normally be able to claim a foreign tax credit for the taxes paid on the income in the source country. From a Canada perspective, this tax is often at a higher rate than the US tax that would be applicable to this income. Any excess tax credits could be carried forward to future years. As a result, you may be forgoing useful foreign tax credit carry forwards that could be used in future years by filing form 2555. Lastly, in some cases, you may in fact be over complicating your tax return by claiming the foreign earned income exemption if you still need to file forms to claim foreign tax credits.

In the end, it’s good to be aware that the foreign earned income exclusion exists and to take advantage of it when it is beneficial to do so, but do keep in mind that it is not always the best option.

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Tony Theaker

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The information contained in this article is for general use only and should not be viewed as professional advice. Accounting and tax rules and regulations regularly change and individuals should contact a competent professional to obtain accounting and tax advice based on their specific situation.

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