Expat taxes aren’t easy. They depend on what you do for a living. They depend on where you do it, what taxes the local government charges, where you hold investments, which passports you hold and much more. For Americans who live overseas, however, the foreign earned income exclusion is a critical part of your annual filings. Here’s how it works. Given the complexity of expat taxes, it’s only prudent to work with a financial advisor on your taxes.
What Is the Foreign Earned Income Exclusion?
As American expatriates will tell you, the U.S. does things a little differently from many Western nations. Americans owe taxes on their income no matter where they earn it worldwide. This contrasts, say, with many EU nations, which only levy taxes on income that citizens earn while working domestically.
There’s a catch, however. While you owe the government taxes on all income earned worldwide, you can qualify to exclude income earned overseas from your income taxes. This is called the foreign earned income exclusion, and, along with the foreign housing deduction and the foreign housing exclusion, it is one of the major tax breaks which inure to U.S. citizens who live and work abroad.
This exclusion allows qualifying taxpayers to exempt a portion of their income from U.S. federal income taxes altogether. In 2023, you may claim it for up to the first $120,000 ($126,500 in 2024) that you earn. This means that if you earn $120,500, say, you would pay federal income taxes on a total of: $120,500 (your income earned) – $120,000 (the maximum exclusion) = $500.
Like the foreign tax credit, the purpose of the foreign-earned income exclusion is to prevent double taxation. It makes sure that you aren’t taxed twice (once by the local government and once by the U.S. government) on the same income.
Claiming the Foreign Earned Income Exclusion
As noted above, the foreign-earned income exclusion functions as a tax deduction. It allows you to deduct all of your qualifying, foreign-earned income from your U.S. taxable income.
You may claim this exclusion under three circumstances:
- You are a U.S. citizen who was a resident of a foreign country or countries for the entire taxable year (the bona fide residence test);
- You are a U.S. citizen or a U.S. resident alien who was physically present in a foreign country or countries for at least 330 complete days during a period of 12 consecutive months (the physical presence test);
- Or you are a U.S. resident alien who is a citizen or national of a foreign country with which the U.S. has an income tax treaty and who resided in that country for the entire taxable year.
In the first category, establishing bona fide residence is a case-specific test. Per the IRS:
It is determined by the facts of your situation and may include such factors as your intention or purpose for being in the foreign country, your activities in the foreign country, and whether you paid taxes to the foreign country, among other things. The IRS decides whether you qualify as a bona fide resident of a foreign country largely based on facts you report on Form 2555, Foreign Earned Income. The IRS cannot make this determination until you file Form 2555.
In the second category, it’s important to note that you don’t need to live abroad for 330 consecutive days. You can come home from time to time, just so long as you live abroad for at least 330 days out of 12 consecutive months. It also does not need to apply to the same taxable or calendar year. You can qualify for the physical presence test even if the 12 consecutive months bridge two separate years.
If you qualify based on one of these three tests, you may deduct up to the maximum amount (again, $120,000 in 2023) from your taxable U.S income. This can only apply to money earned while working overseas. Any money that you earned while working or living in the U.S., most money earned off of investments or any money in excess of the cap, is not subject to the deduction.
Exceptions to the Exclusion
Pay received as part of the military or a civilian employee of the U.S. government does not qualify for this deduction. This is in part because you generally will not be taxed by local governments (and if you are, you likely may claim the foreign tax credit). However, it can apply to working spouses of foreign-based employees of the U.S. government. Further, self-employed workers should note that like all tax deductions this does not apply to your self-employment tax. It only applies to the personal income tax.
You can only claim this deduction for earned income. The IRS has a more complete guide on its website here, but earned income generally includes wages, salaries, professional fees and tips. It does not include categories such as dividends and interest, capital gains or gambling winnings. Depending on your individual circumstances business income can qualify, and most self-employed people or freelancers will qualify for this deduction.
As a final note it is essential to understand that this applies only to federal income taxes. If you are still a legal resident of the United States you are legally required to maintain a state or territory of residence. Unless you change that state of residence, it will typically remain the last state or territory in which you paid taxes. You must continue to comply with all tax laws of your state of residence.
Bottom Line
There are a number of tax issues that Americans working or living abroad should be aware of. One of the most important is the foreign-earned income exclusion, which is a tax deduction that allows American citizens or legal residents to deduct from their federal tax returns the income they earned while living and working overseas. In 2023 it allows you to deduct a maximum of $120,000 of your earnings from federal income taxes.
Tips on Taxes
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s tax calculator can show you what you might owe this year.
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