U.S. Taxation: The Foreign Earned Income Exclusion
by George Gonzalez
Are you a U.S. citizen moving to a foreign country for work? If so, read on.
As a U.S. citizen you are subject to taxation of worldwide income regardless of where you live. “Worldwide income” means income from all sources, both U.S. source and foreign source. You must file the annual 1040 tax return If your worldwide income is above the filing requirement threshold (currently approximately $13,000 for single filers and $26,000 for joint filers, although for self-employed individuals there is also an additional threshold). Nevertheless, U.S. citizens who reside on a full-time basis outside of the U.S. are entitled to some tax breaks.
There are three main tax breaks that I discuss in these web pages. In this article I focus on the Foreign Earned Income Exclusion and, in separate articles, the Housing Exclusion and the Foreign Tax Credit.
Foreign Earned Income Exclusion in General
The Foreign Earned Income Exclusion (FEIE) allows a qualifying individual to exclude earned income, up to specified limits, from their taxable income. This means the U.S. does not tax the excluded income at all. The FEIE applies only to foreign earned income. Earned income is either employment income that you earn as an employee or self-employment income earned from running a business under your own name. Earned income would not include any other type of income such as dividends, interest, pension income, social security income, etc.
The limit on the amount of earned income that can be excluded under the FEIE rules changes each year, to take inflation into account. For 2023 the limit is $120,000. Thus, if you earn foreign income of $120,000 or less, you may exclude all of it from U.S. taxation. If you earn more than $120,000, only the excess is taxable.
The FEIE is available as an election. You may choose to avail yourself of it, or you may choose not to. Depending on your circumstance, such as your total income, the tax rates in the country where you reside, etc., it may or may not be beneficial to elect under the FEIE. While the FEIE is generally beneficial to elect, under some conditions it may better to forego the FEIE election and instead rely on the Foreign Tax Credit to reduce U.S. taxes. I discuss the Foreign Tax Credit in a separate article.
Two Main Residency Tests
To qualify for the FEIE, you must meet one of two general tests: the bona fide residence test or the physical presence test. If you do not meet one of these two tests then you cannot avail yourself of the FEIE. This could be the case, for example, if you work in a foreign country for a short period such as six months or some other period less than a year. One of these two tests must be met every year to continue qualifying for the FEIE.
To qualify under the bona fide residence (BFR) test, you must live in a foreign country for a period that includes a full calendar year (January 1 through December 31). The requirement under the physical presence (PP) test is to be present in a foreign country for 330 days in a 12-month period. Unless you moved to a foreign country on January 1, you would probably use the PP test for the year that you moved to the foreign country. In subsequent calendar years, when you reside in the foreign country for the full calendar year, you can rely on the BFR test rather than the PP test. The BFR has its advantages so it is often a good approach to claim FEIE under the BFR test rather than under the PP test whenever possible.
For a partial year, such as the year that you moved to the foreign country or the year that you moved back to the U.S., the previously mentioned FEIE limit ($120,000 for 2023) is prorated based on the number of days during the calendar year that you resided in the foreign country. So, for example, if you moved to a foreign country on February 1 of 2023, and ultimately qualified for the PP test for that calendar year, you will have been in the foreign country for 334 out of 365 days. Accordingly, the maximum amount of earned income that you could exclude under the FEIE for that year would be $120,000 x 334 / 365 = $109,808.
I mentioned that, once you can start qualifying for the BFR test, it has its advantages over the PP test. This is because under the BFR test you may return to the U.S. for temporary trips back; while the number of days present in the foreign country is used to determine whether you qualify for the FEIE under the PP test, it is not under the BFR test. Under the BFR test you simply must legally reside in the foreign country for the full calendar year, and trips to the U.S. during the year are allowable.
FEIE Does Not Apply to U.S. Source Income
It is important to note that the FEIE is applicable to foreign earned income only; income earned from days worked in the U.S. do not qualify for the exclusion. Therefore, if you returned to the U.S. for work for a period of time during the year, you would have to allocate earned income between U.S. income and foreign income. You would do this based on the number of days that you worked in the U.S., and as a result only the foreign portion of your earned income would be excludable under the FEIE.
For example, assume the following. You earned $120,000 in employment income during the year. Out of 240 working days during the year you worked 210 in the foreign country and 30 in the U.S. Thirty days out of 240 is 12.5%. You would allocate 12.5% of your earned income to U.S. source income ($120,000 x 12.5% = $30,000) and the other 87.5% to foreign source income ($120,000 x 87.5% = $90,000). Accordingly, you will be able to exclude foreign source income of $90,000 under the FEIE and the U.S. source income of $30,000 would be fully subject to tax.
Marginal Tax Rate Stacking
A noteworthy point about how the FEIE works is that any earned income that exceeds the FEIE limit is subject to tax at the rate that would have applied without the exclusion. This is referred to as “stacking”. An example is a good way to illustrate this.
Assume that you are a single taxpayer who had $160,000 in foreign earned income in 2023 and excluded $120,000 of it under the FEIE. The excess of $40,000 would therefore be subject to tax. To keep things simple, let’s further assume that you had no other income and let’s ignore deductions. Without stacking, the $40,000 would be taxed at a marginal rate of 12%, since the second tax bracket for 2023 applies to taxable income between $11,000 and $44,725.
However, with stacking the $40,000 would be taxed at a marginal rate of 24%. This is because the total foreign earned income, before the exclusion, is $160,000, and for 2023 taxable income between $95,375 and $182,100 is taxed at a 24% rate. In this example stacking results in a marginal tax rate that is double what it would otherwise be (24% versus 12%).
The FEIE is an Election
Assuming you qualify for it, you claim the election to use the FEIE in the tax return for the first year that you want to avail yourself of It. You are subsequently deemed to elect it every year thereafter unless you revoke it. After a revocation is made, you may not go back to using the FEIE for five years, unless you get specific approval to use the FEIE again from the IRS. Hence, revoking the FEIE should only be done after careful analysis and consideration.
Revocation of the FEIE could be beneficial depending on circumstances. (A quick note: when you use the FEIE your Foreign Tax Credit is reduced based on the percentage of your foreign earned income that is excluded. This is discussed in a separate article on the Foreign Tax Credit.) When I first left the U.S. and started worked abroad, I availed myself of the FEIE as it allowed me to exclude all of my foreign earned income from U.S. taxation. A few years later, however, my foreign earned income was above the FEIE limit. Based on my calculations I found that if I continued using the FEIE I would pay more in taxes than I would if I had full use of the Foreign Tax Credit. So, I revoked the FEIE and from that point forward filed tax returns using the full amount of the Foreign Tax Credit, and thereby saved on taxes. The Foreign Tax Credit is the topic of another article in these web pages.