How to Use the US Foreign Earned Income Exlusion (FEIE)
As discussed in my previous post, “Basics of US Income Taxes for Americans Living Overseas“, there are two paths to reducing or eliminating US taxes on income that you’ve earned in a foreign country. Bear in mind that in all likelihood you’ve already paid income taxes to the country you’re living in. Therefore, you’d probably like to avoid paying US taxes on your income as well! In this post, I’m going to focus on the specifics on the foreign earned income exclusion (FEIE) including eligibility, what kind of income it applies to and how to use the exclusion. In my next couple of posts, I’ll be covering the foreign housing exclusion and deduction and then the second method of reducing your US taxes, the foreign tax credit.
The Foreign Earned Income Exclusion is currently suffering from the same problem as the Alternative Minimum Tax (AMT). Originally intended to capture only wealthy individuals when it was introduced in 1982 at a cap of $75,000, it was not indexed to inflation at that point. The FEIE was only indexed to inflation beginning in 2005, and therefore subjects greater numbers of individuals with average incomes to double taxation. If the FEIE had been indexed to inflation from the beginning, it would be now stand at $166,000 in 2008. A very interesting (but long) article about the history and current issues of taxing Americans living abroad can be found here.
What qualifies as earned income?
- Salaries and wages
- Commissions
- Bonuses
- Professional fees
- Tips
The following items may qualify as earned income, but will depend on your specific circumstances:
- Business profits
- Royalties
- Rents
- Scholarships and fellowships
- Lodging, meals or use of a car provided by your employer
Unearned income (not excludable under the foreign earned income exclusion):
- Dividends
- Interest
- Capital gains
- Gambling winnings
- Alimony
- Social security benefits
- Pensions
- Annuities
You might have noticed above that pensions and annuities are not covered by the FEIE. This means that if you are retired and living abroad, you will owe US taxes on the full amounts of monies paid out to your from your pensions and annuities! However, I believe distributions from traditional IRAs are treated as ordinary earned income and therefore can be excluded by the FEIE as long as you are older than 59.5 when you take the distribution. For Roth IRAs, all distributions should be tax-free, again as long as you are older than 59.5.
If you meet either the bona fide residence test or physical presence test and your tax home is in a foreign country, you can use the foreign earned income exclusion. The bona fide residence test is met by setting up residence in a foreign country and having lived there for an entire tax year with the expectation that your residence will be of an indefinite time frame (e.g. not a temporary assignment). The physical presence test is met by being in a foreign country for 330 days over a consecutive 12 months. Either of these test qualify you to take the FEIE. In 2008, the excludable amount is $87,600. If you are married and your spouse is also subject to US taxes, you can both take the exclusion and exclude up to $175,200.
Once you make the choice to use the foreign earned income exclusion, it remains in effect until you revoke it. You can revoke your choice by attaching a statement to your tax returns. Please note that if you decide to use the FEIE again within 5 years, you have to apply to the IRS for approval.
Possible Drawbacks
If you don’t earn more than the FEIE cap ($87,600 in 2008), it’s good news in that you won’t owe US taxes in addition to the foreign taxes you’ve probably already paid on the income. However, if you are planning to continue contributions to an US traditional IRA, Roth IRA or 529 college savings plan, you will not be able to do so if all our foreign income is excludable. This is due to the fact that all of these accounts are tax-advantaged, and if you’re excluding your income from US taxes, you cannot receive the tax benefits. I’ll talk about one way to continue funding these accounts in a subsequent post on the foreign tax credit.
In addition, use of the FEIE may also affect your ability to take normal credits and deductions such as the the Child Tax Credit.
Interaction with the Foreign Housing Exclusion
In my next post, I’ll be explaining how the foreign housing exclusion and deduction work. If you use the foreign housing exclusion, it reduces the amount of the income that you can exclude.
Forms
To claim the foreign income and housing exclusions, you will need to file Form 2555 (instructions can be found here). If you’re only claiming the foreign income exclusion, are not self-employed and make less than $87,600, there is also a short version, Form 2555EZ (instructions can be found here). Both of these forms would be filed with your other tax forms.
Resources
IRS Publication 54 – Tax Guide for U.S. Citizens and Resident Aliens Abroad
Disclaimer
Please note that I am not a tax professional. The above post is for informational purposes only. If you have specific tax issues related to living outside your home country, you should contact a tax professional.
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Nice site. There
Thanks, Susan. Is there something in particular you were looking for on this topic?
hi,
There is another quite obscure rule about things considered income: contributions by your employer to your pension fund–it should be added to your annual salary. Here is one reference about this: https://www.usluo.org/tax-info-sept-2009/Tax_Info2.pdf (see “Questions related to declaring Pillar accounts:”, item #1)