Foreign Tax Credits (FTC) vs Foreign Earned Income Exclusion (FEIE)

The tax affairs of US expats are always more complicated than for American citizens living in the US because the expats are still required to file their worldwide income in the US, regardless of where they live.

This creates the distinct possibility that you will be required to pay tax in both the US and at least one other country, thus being taxed more than once on the same income.

Such double taxation can be avoided relatively simply, and the two primary methods are either through Foreign Tax Credits (FTC) or Foreign Earned Income Exclusion (FEIE).

We have created this article for US citizens living outside the US as well as US tax residents who also earn income from outside the US and need to know how to legitimately avoid being taxed twice on the same income. It provides an explanation of both Foreign Tax Credits and Foreign Earned Income Exclusion, how they work and how they compare to each other – providing some clarity over which approach is best for you.

While this article provides explanations, and it is possible to manage your taxes yourself, you should not rely solely on the information below and should always seek assistance from a trusted US tax specialist as making mistakes could be costly.

Overview Of Foreign Tax Credits

Foreign Tax Credits (FTC) are a way for American expats and American connected people to claim back tax from the US Government which has already been paid in a different tax jurisdiction.

Types of income which are eligible for foreign tax credits include income from wages, dividends and royalties, however not all types of income are eligible, and you should check before assuming you can apply for foreign tax credits.

Using foreign tax credits could reduce the amount of tax you have to pay if the country you pay the tax in has a more favorable tax rate that the US.

As a simple example, if you earn $125,000 while living and working in the UK and paid $44,000 in taxes to the UK government, you would be able to apply for a tax credit of $44,000 when you submit your US tax return.

How To Calculate and Apply For Your Foreign Tax Credits

• Calculate the tax paid to the foreign government.
• Calculate your US tax liability – i.e the amount you would owe the US Government if you were not applying for a foreign tax credit.
• When completing your US tax return also complete and file Form 116 which includes the foreign income earned and taxes already paid to a foreign government. Form 116 also requires you to identify types of income (such as passive and general income) to ensure credits are correctly applied.
• Incorporate any excess foreign tax credit carryovers from previous tax years.

Foreign Tax Credit Limitations and Carryovers Explained

If you paid more tax to a foreign government that you would have had to pay to the US Government, this excess cannot be used as a tax credit. However, any tax credits which cannot be used in the same tax year can be carried over into either the previous tax year – or any of the subsequent 10 tax years.

Refundable vs Non-Refundable Tax Credits

You will only be able to receive a tax refund if your tax credit was refundable and the tax credit was more than the tax owed to the US government. However, most tax credits (including foreign tax credits) are non-refundable and therefore if the tax owed in the US is less than the tax credit itself, the tax owed would be zero, but you would not be entitled to a refund.

Overview Of Foreign Earned Income Exclusion

Unlike most countries, US citizens and US resident aliens are subject to US tax on their worldwide income even if they are not a tax resident in the US.

However, Foreign Earned Income Exclusion (FEIE) enables Americans who work and live abroad – and are considered a tax resident of another country - to exclude foreign earned income from the US tax returns and therefore pay no US tax on qualifying income.

Unlike Foreign Tax Credits, Foreign Earned Income Exclusion excludes certain income from your US tax liability rather than being issued with tax credits following your tax return.

To qualify for FEIE you would need to earn income from another country and meet one of the following criteria:

• Be an American citizen and you are a tax resident of another country, specifically for an uninterrupted period which includes an entire US tax year.
• Be a foreign national, but US resident alien, who is considered a tax resident of another country for an uninterrupted period which includes an entire US tax year.
• Be either a US citizen or US resident alien who lives outside the US for 330 days in any given tax year/consecutive 12-month period.

Maximum Annual Exclusion Amount

The annual maximum exclusion amount (i.e. the maximum amount of foreign earnings you can exclude each tax year under FEIE) increases each tax year in line with inflation. For tax year 2023, the maximum exclusion amount is $120,000. This means that if you earn over $120,000 in foreign income in tax year 2023, you can only exclude up to $120,000 for that tax year.

Any amount over this figure will still be subject to US tax, so if you earned $145,000 from foreign income sources in 2023 and were eligible for FEIE, you would be able to exclude $120,000 from US tax but have to pay US tax on the remaining $25,000.

For reference, previous years’ annual maximum exclusion amount are as follows:

• 2023: $120,000
• 2022: $112,000
• 2021: $108,700
• 2020: $107,600

FEIE Qualifying Income Sources

Not all foreign earned income will qualify for FEIE. In essence, to qualify your income would need to be from wages, salary, or fees from services which you have provided.

Income which is not eligible for FEIE includes:

• Dividends or profit share.
• Pay which is received from US civil service, military or any other US government agency.
• Income which has not been earned in another country (i.e. in international waters or airspace).
• Payments received outside the tax year, even if the work was conducted within the tax year.
• Pensions or annuity payments.
• Non-financial “payments” such as receipt of food or lodgings or the equivalent value
• Any other passive income sources.

Claiming FEIE

To calculate the amount of foreign income which can be excluded from your tax return, you will need to complete Form 2555 within your US tax return and subtract the excluded amount on your tax return.

Tax In Other Countries

FEIE enables people to exclude their foreign earned income from their US tax return, however this does not mean that the income will not be subject to tax in other jurisdictions – most likely where you are considered tax resident and/or the country where the tax was earned.

Therefore, you must always seek advice to ensure you are compliant with the tax rules in all jurisdictions where you have a fiscal presence.

Can I Use Both Foreign Tax Credits and Foreign Earned Income Exclusion on The Same Tax Return?

Yes, it is possible to use both Foreign Tax Credits *AND* Foreign Earned Income Exclusion on the same tax return in the same tax year. However, you cannot apply both schemes for the same income. For foreign earned income you will have to decide whether it is best to claim foreign tax credits, exclude earnings from your tax return – or potentially ignore both schemes and pay US tax on your foreign income.

Which scheme you use will essentially come down to what the income is eligible for and the tax rates which the income will be subject to.

Comparing Foreign Tax Credits and Foreign Earned Income Exclusions

Assuming that the US tax rate on income is less favorable than in another country, the following factors should be taken into consideration when making your decision.

1. Tax rates: Typically, if the US tax rate is lower than the other country, you may find that tax credits are more favorable. Conversely, if the US tax rate is higher, then using FEIE and excluding the income from your US tax return may be more favorable.
2. Income levels: If your foreign earned income is significantly higher than the maximum exclusion amount, you will likely find that using foreign tax credits is more favorable as there is no cap on the credits allowed and therefore no part of your foreign earned income will be taxed twice.
3. Eligibility: Not all income is eligible for FEIE or FTC, so it may be as simple as applying whichever scheme is available for your foreign earned income.
4. Long-Term vs Short-Term: Foreign Tax Credits offer opportunities to carry forward unused credits, which is especially useful if you are expecting your foreign earned income to increase in subsequent years.
5. Refunds can take time: Foreign Tax Credits also take time to be applied, so any refunds can take time to be applied which means you may face a delay and pay tax in more than one jurisdiction in the short term. You will be subject to the US Government’s own timescales to get your tax credits applied. FEIE ensures that your income is immediately excluded, so you won’t ever be subject to tax on that income.
6. Documentation: Foreign Tax Credits require more paperwork, currency conversions and calculations which increases the time taken to apply in the first place. Foreign Earned Income Exclusion is relatively straightforward as you only have to report the amount you earned from foreign sources.

Always Speak to a US Tax Specialist Before Any Decisions

While it is possible to complete your US tax return and claim Foreign Tax Credits and/or Foreign Earned Income Exclusion, making a mistake can mean you end up paying more tax than is necessary.

As mentioned at the beginning of this article, you should never rely solely on information on the internet, or from what your friends have suggested. Always seek help from a trusted US tax specialist who also has an excellent understanding of international tax matters commonly faced by US expats.

By consulting with a US tax specialist, you can ensure that your tax returns will be optimized in line with the correct applications of credits and exclusions, ensuring you are never overpaying tax in the US or any other country.

We offer a free introduction to trusted US tax specialists which also includes an initial free consultation enabling you to have your general questions answered – including whether you can potentially reduce your US tax liabilities.

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