For US citizens living abroad, two primary tax benefits can help reduce their US tax liability: the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE). While both aim to prevent double taxation, they function differently and are subject to specific eligibility requirements. Understanding when to use one over the other can significantly impact your tax savings.
The Foreign Tax Credit (FTC)
The Foreign Tax Credit allows US taxpayers to reduce their US tax liability on income that has already been taxed by a foreign government. The goal is to prevent double taxation on income earned abroad. The credit is generally claimed using Form 1116 and is based on the amount of foreign taxes you’ve paid or accrued during the tax year.
When to Use the Foreign Tax Credit:
- You have foreign taxable income: The FTC is ideal if you earn income that is taxed by a foreign country, such as wages, dividends, or business income. For example, if you’re employed in a foreign country that taxes your salary, the FTC can reduce your US tax liability by the amount of foreign taxes paid, up to the limit.
- Your foreign income exceeds the FEIE limit: If your foreign-earned income exceeds the maximum exclusion limit for the FEIE (which is $126,500 for tax year 2024), using the FTC can be more beneficial. The FTC allows you to claim credits for taxes paid on income that exceeds the FEIE threshold.
- Foreign taxes are higher than US taxes: If the foreign taxes paid are higher than the US taxes you would owe on the same income, the FTC allows you to claim the full amount of the foreign tax, providing more tax relief. You can also carry over unused foreign tax credits to future years.
The Foreign Earned Income Exclusion (FEIE)
The Foreign Earned Income Exclusion allows qualifying US citizens to exclude a certain amount of foreign-earned income from US taxation. For 2024, the exclusion is up to $126,500. In addition to earned income, the FEIE may also apply to certain housing expenses. This exclusion is claimed on Form 2555.
When to Use the Foreign Earned Income Exclusion:
- You are eligible for the exclusion: To qualify for the FEIE, you must meet either the Bona Fide Residence Test or the Physical Presence Test. If you’re a resident of a foreign country or have been physically present outside the US for at least 330 days in a 12-month period, you may qualify.
- You have no foreign taxes paid or paid very low foreign taxes: If you earn foreign income but pay little or no foreign taxes, the FEIE might be more advantageous because it allows you to exclude up to the maximum amount of foreign-earned income from US taxation, reducing your taxable income.
- You are only earning wages or salary: The FEIE applies only to earned income, such as salary or wages. If you only have wages from a foreign employer and meet the eligibility requirements, the FEIE is an easy way to reduce your taxable income without dealing with foreign tax credits.
Key Differences Between FTC and FEIE
| Factor | Foreign Tax Credit (FTC) | Foreign Earned Income Exclusion (FEIE) |
| Eligibility | Available for most types of foreign income (e.g., wages, dividends, capital gains) | Applies only to foreign-earned wages or salary |
| Exclusion Amount | No limit on the amount of foreign taxes you can credit (up to foreign tax liability) | Exclusion up to $126,500 (2024) for qualifying foreign-earned income |
| Additional Deductions | Reduces tax liability dollar for dollar on taxes paid to foreign government | Reduces taxable income but cannot be claimed for other types of income (e.g., investment income) |
| Double Taxation Relief | Credits foreign taxes paid, reducing US tax liability on the same income | Excludes foreign wages or salary from taxable income entirely |
| Form Requirements | Requires filing Form 1116 | Requires filing Form 2555 |
| Additional Benefits | Can carry over unused credits to future years. | May also exclude certain foreign housing expenses |
Can you use both the Foreign Tax Credit and the FEIE?
In some cases, US expats can use both the Foreign Tax Credit and the Foreign Earned Income Exclusion to reduce their tax liabilities. However, you cannot double-dip on the same income. For example, if you exclude your earned income under the FEIE, you cannot apply the same income for the FTC. However, if you have income that is not excluded under the FEIE (such as investment income), you can use the FTC to reduce taxes on that portion of your income.
Which option is right for you?
Choosing between the Foreign Tax Credit and the Foreign Earned Income Exclusion depends on your specific circumstances. The FTC is more beneficial if you pay significant foreign taxes, earn income beyond the FEIE limit, or have different types of income. On the other hand, the FEIE is straightforward and offers immediate tax relief for those with qualifying earned income below the exclusion limit.
For many expats, a combination of both might be the best strategy. It’s essential to review your tax situation carefully, as well as consult with a tax professional, to ensure you’re maximizing your tax benefits while staying compliant with US tax laws.
