Foreign Earned Income Has Huge U.S. Tax Benefits
- Can you earn tax-free income from working abroad?
- Learn about foreign earned income and housing exclusions.
- Find out about foreign self-employment income.
- Learn about claiming or revoking the exclusion.
U.S. citizens and resident aliens must pay taxes on their worldwide or foreign earned income. And they must do this whether they live in the U.S. or in another country. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.
This exclusion applies to both employees and self-employed individuals. In addition to the excludable income, this can also be an attractive option to individuals who wish to travel the world. Today’s digital world allows individuals, armed with their computers and a Wi-Fi connection, to work from anywhere.
So, for example, if you would like to be a digital wanderer and your employer approves or you are self-employed, you can travel the world while earning income from your employer or your self-employment clients. Some employers may nix the idea because they don’t want their business to be entangled in foreign taxes. You should check into what your tax filing responsibility will be with any foreign country where you are thinking of working.
If you do work abroad for a U.S. firm, you can still have payroll disbursements (and client payments if self-employed) deposited in your U.S. bank account, charge expenses on your credit card, and use online banking to make credit card payments, thus avoiding any foreign bank account reporting.
The Foreign Earned Income Exclusion
You will still have to file a U.S. 1040 tax return and report your income the same way as if you were living and working in the U.S. However, if you meet certain requirements, you will be able to exclude some or all of your foreign earnings from income tax.
To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:
- Have foreign earned income (income received for working in a foreign country, including payroll disbursements from a U.S. employer and self-employment income);
- Have a tax home in a foreign country; and
- Meet either the bona fide residence test or the physical presence test.
The IRS adjusts the foreign earned income exclusion amount annually for inflation. For 2022, the maximum is up to $112,000 per qualifying person.
If you are married and both you and your spouse (1) work abroad and (2) meet either the bona fide residence test or the physical presence test, each of you can choose the foreign earned income exclusion. Together, you can exclude as much as $224,000 for the 2022 tax year. However, if one of you uses less than 100% of their exclusion, you cannot transfer the unused amount to the other spouse.
Exclude or Deduct Foreign Housing
In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct a foreign housing amount from their foreign earned income.
The amount of qualified housing expenses eligible for the housing exclusion and housing deduction has a general limitation of 30% of the maximum foreign earned income exclusion. The housing amount limitation is $33,600 for the 2022 tax year. However, the limit will vary depending on where the qualifying individual’s foreign tax home is located and the number of qualifying days in the tax year.
The foreign earned income exclusion is limited to the actual foreign earned income minus the foreign housing exclusion. Therefore, to exclude a foreign housing amount, the qualifying individual must first figure out the foreign housing exclusion before determining the amount for the foreign earned income exclusion.
The Fine Print on Foreign Earned Income
Before you become overly excited about working from some exotic locale, foreign earned income does not include the following amounts:
- Pay received as a military or civilian employee of the U.S. Government or any of its agencies.
- Pay for services conducted in international waters (not a foreign country).
- Pay in specific combat zones, as designated by a Presidential Executive Order, that is excludable from income.
- Payments are received after the end of the tax year when the services were performed to earn the income.
- The value of meals and lodging that are excluded from income because they were furnished for the employer’s convenience.
- Pension or annuity payments, including Social Security benefits.
As stated previously, a qualifying individual may also claim this exclusion on foreign-earned self-employment income. The excluded amount will reduce the individual’s regular income tax but will not reduce his or her self-employment tax. Also, they may claim the foreign housing deduction—instead of a foreign housing exclusion.
A qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions. In other words, the exclusion is “off the bottom,” not “off the top.”
Once you choose the foreign earned income exclusion, you cannot claim a foreign tax credit—or a deduction for foreign income taxes—on the income that can be excluded. If you claim a foreign tax credit or tax deduction for any of the foreign taxes on the excluded income, the foreign earned income exclusion may be considered revoked.
Other issues to Consider When Working Abroad
Earned income credit
Once you claim the foreign earned income exclusion, you cannot claim the earned income tax credit for that year.
Timing of election
Generally, a qualifying individual must initially choose the foreign earned income exclusion with one of the following income tax returns:
- A return filed by the due date (including any extensions);
- A return amending a timely filed return;
- An amended return, which you generally must file by the later of 3 years after the filing date of the original return or 2 years after you pay the tax; or
- A return filed within 1 year from the original due date of the return (determined without regard to any extensions).
A qualifying individual can revoke an election to claim the foreign earned income exclusion for any year. They may do this by attaching a statement to the tax return revoking one or more previously made choices. The statement must specify which choice(s) are being revoked. Why you may ask? Because the election to exclude foreign earned income and the election to exclude foreign housing amounts must be revoked separately.
What if the qualifying individual chooses to revoke an election and then wishes to choose the same exclusion again within 5 years? Then he or she must apply for approval by requesting a ruling from the IRS.
What if your U.S. state of residence when departing the U.S. is one with state income tax? Then you may be required to report all of the foreign income on the state tax return unless there is an exception.
Are you considering foreign employment or traveling abroad while working? Before you make your final decision, call your Fiducial representative. We can tell you more about the foreign earned income and housing allowance exclusions. Feel free to ask about how to meet the bona fide residence or physical presence tests too.
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