FEIE vs Foreign Tax Credit: Which to Choose and Can You Switch

FEIE (Form 2555) vs foreign tax credit (FTC, Form 1116): which comes out ahead?

In a country with no or low income tax, the foreign earned income exclusion (Form 2555) often leaves less US income tax, because the foreign tax credit (FTC, Form 1116) can only offset US tax with foreign income tax you actually paid. In a high-tax country, the credit can often remove US income tax on the same pay, and it keeps the refundable child tax credit and IRA room that the exclusion takes away. Where foreign tax is below the US tax on the same pay, the credit leaves the difference to pay, so children, IRA plans and the five-year lock decide it. Neither is automatic: figure the whole return both ways (IRS: choosing the exclusion).

Sources: Form 2555 instructions, Publication 54, Publication 514, Publication 590-A.

A case stops being simple when you have children, pay above the exclusion limit, plan a move to a lower-tax country within five years, want to change years already filed, have a spouse who is not a US person, or keep ties to a state. Gather your foreign tax returns or assessments, pay slips, prior US returns with any Form 2555 or Form 1116, IRA statements, and Social Security numbers: a child without a valid one cannot be claimed for the child tax credit, and on a joint return at least one spouse needs one (Schedule 8812 instructions).

Whether you qualify for the exclusion at all is covered in the exclusion tests guide. Whether you must file, and the housing exclusion, are covered in filing while living abroad.

Why does the FEIE still leave US tax to pay?

The exclusion covers only foreign earned income up to the yearly limit, and it raises the rate on everything else. Three things commonly leave a bill:

• Pay above the limit. Pay over $132,900 (plus any housing exclusion) stays taxable.
• Other income. Interest, dividends, capital gains, rent and pensions are not earned income, so the exclusion never touches them.
• Higher rates on what is left. With the exclusion or the housing deduction, tax on the remaining income is figured using the rates that would have applied without the exclusion. The Foreign Earned Income Tax Worksheet in the Form 1040 instructions adds the excluded amount back, figures tax on the total, then subtracts the tax on the excluded amount alone. Your other income lands in the upper brackets.

Self-employed people also still owe US self-employment tax: foreign self-employment earnings cannot be reduced by the exclusion (Schedule SE instructions). Whether a totalization agreement removes it is covered in self-employment tax abroad.

Can I use both the FEIE and the foreign tax credit in the same year?

Yes, on different income. You can exclude pay up to the limit, then claim the credit for foreign tax on pay above the limit and on other foreign income such as interest or dividends (Publication 54).

You cannot take a credit or deduction for foreign tax on pay you excluded. When pay is only partly excluded, the foreign tax on it is split by a fraction: excluded pay over total foreign earned income, each reduced by related expenses. Only the share for the taxable part can be credited (Publication 514).

Claiming a credit or deduction for foreign tax on income you could have excluded can revoke the exclusion, starting with that year (IRS: choosing the exclusion). How the credit's categories and limit work is covered in the foreign tax credit limit guide.

FEIE and the child tax credit: what do you lose?

Anyone who files Form 2555 cannot claim the additional child tax credit, the refundable part of the child tax credit (Schedule 8812 instructions). The nonrefundable part can only reduce the US tax left after the exclusion, which is often none, so a family on the exclusion may get little or nothing from the child credit. The earned income credit is lost too, and taking only the foreign housing deduction has the same effect on both credits (Form 2555 instructions). The child credit's income phase-out is measured with the excluded pay added back, so a large salary can shrink the credit even when little of it is taxed (26 U.S.C. 24(b)).

Under the foreign tax credit, the credit is subtracted from your tax first, before the child credit is measured (Credit Limit Worksheet A). The child credit that tax cannot absorb may then be paid out as the additional child tax credit, subject to its own earned income formula and per-child cap (Schedule 8812 instructions).

Trap: claiming the additional child tax credit or the earned income credit in a later year counts as revoking a prior exclusion election for that year (Publication 54). You then cannot elect the exclusion again for five tax years without IRS approval (see the lock below).

Can I contribute to a Roth IRA or traditional IRA with the FEIE?

Only if you have compensation the exclusion did not remove. Contributions to traditional and Roth IRAs are limited to the smaller of the yearly limit ($7,500 under age 50) or taxable compensation, and excluded foreign pay does not count as compensation (Publication 590-A; Publication 54). If the exclusion removes all your pay, you have no room of your own.

Room can still come from pay above the limit, or from a spouse's taxable compensation on a joint return (Publication 590-A).

Two different tests apply:

Source: Publication 590-A, Worksheet 2-1.

I contributed while excluding all my pay: how do I fix the excess?

Withdraw the excess contribution and its earnings by your return's due date, including extensions, and the yearly excise tax of 6% does not apply (Publication 590-A). Left in place, the excess is taxed at that rate for every year it remains at year-end, reported on Form 5329.

• Earnings go with it. The earnings withdrawn are taxable for the year of the contribution. A corrective withdrawal made by the due date, including extensions, is not subject to the additional tax on early distributions.
• Already filed on time? You can still have the contribution returned within six months of the original due date, excluding extensions, and file an amended return with "Filed pursuant to section 301.9100-2" written at the top.
• Missed that window? You can apply the excess to a later year with unused room, or withdraw it later. A later withdrawal from a traditional IRA stays out of income only if that year's contributions were within the dollar limit and you took no deduction for the excess. Either way, the tax applies for each year-end it remained (Publication 590-A).
• Change method for that year? Claiming the credit instead of the exclusion on that pay makes it compensation again. That is a revocation, so weigh the five-year lock first.

Excesses spread over several years need each year traced; see cross-border tax help.

Can I switch from the FEIE to the foreign tax credit (FTC)? The five-year lock

Yes, but once you revoke the exclusion, you cannot elect it again for your next five tax years without IRS approval (Form 2555 instructions). The exclusion stays in effect every year until you revoke it.

You revoke by attaching a statement to the return, or amended return, for the first year you do not want the exclusion. The foreign earned income and housing exclusions are revoked separately. A revocation is also treated as made when you leave the exclusion off a later year's return, or claim a foreign tax credit on income you could have excluded, or the additional child tax credit or earned income credit in a later year (Publication 54). You do not need to revoke just because you have no foreign earned income for a year.

Source: 26 CFR 1.911-7(b).

Approval within the lock means asking for an IRS ruling, which carries a fee. The IRS weighs facts such as a period of US residence, a move to a country with different tax rates, a big change in the foreign country's tax law, or a change of employer (IRS: revoking your choice). Approval is not assured, so a planned move to a low-tax country is a reason to compare carefully before revoking.

Can I amend past years from FEIE to the foreign tax credit, or back?

Yes, but a revocation on an amended return, even for the first year you elected, applies to that year and every later year (26 CFR 1.911-7(b)). Amending one early year to the credit means every later return filed with the exclusion must be redone on the credit too, and the five-year lock runs from that early year.

Steps, in order:

1. Figure each affected year both ways, including the child credit, IRA effects and state returns.
2. Pick the first year to revoke. Revoking from the current year forward needs no amendments at all.
3. Amend that year with the revocation statement and Form 1116.
4. Amend every later year already filed with the exclusion.
5. Apply unused foreign tax from each redone year first to the year before (carryback), then to later years.

Source: Publication 514.

Whether the longer period covers the whole refund from a revoked-exclusion year depends on what drives the refund; check before relying on it. An amended year can also show more tax due, not less.

Going back from the credit to the exclusion is possible: the election can be made on an amended return for a return that was filed on time, if the amended return is filed within the normal refund-claim period (IRS: choosing the exclusion; 26 CFR 1.911-7(a)). Within five years of a revocation, it needs IRS approval. Foreign tax on the newly excluded pay then drops out of the credit, which can shrink carryovers used in later years.

Example

These examples are illustrative and use US dollars. They show direction, not exact tax.

Teacher in the UAE

A single teacher with no children earns US$90,000 in a country with no income tax. The credit gives nothing, because no foreign income tax was paid. The exclusion can remove the whole salary from US income tax. Cost: no IRA contribution of her own that year, since excluded pay is not compensation.

Engineer in Germany with two children

A married engineer filing jointly with a US citizen spouse who has no income earns US$120,000, the family's only income, and pays about US$35,000 of German income tax. Suppose the US income tax on that salary is about US$10,000, well below the German tax, so the credit can offset all of it. The child credit that tax cannot absorb may then be paid out as the additional child tax credit, within its cap and earned income formula. The salary counts as compensation for IRA contributions. The German tax the credit could not use carries over. On the exclusion, he would lose the refundable child credit and IRA room, and the German tax on the excluded pay could not be credited.

Family in Taiwan, year by year

A family took the exclusion in Year 1 and Year 2 and now, in Year 3, wants the refundable child credit.

• Option A, revoke from Year 3. Attach a statement to the Year 3 return and claim the credit. Years 1 and 2 stay as filed. The exclusion is unavailable without approval through Year 8.
• Option B, amend Year 1. The revocation covers Year 1 and every later year, so Year 2 must be amended to the credit too, and Year 3 is filed on it. Each year is redone with Form 1116. The exclusion is unavailable without approval through Year 6.
• Either way, each amended year may show a refund or more tax, depending on how Taiwan's tax compares with the US tax on the same pay.

Different for you?

• You are not sure you qualify for the exclusion, or this is your first year abroad: see the exclusion tests and first year.
• Form 1116 gives less credit than the tax you paid: see foreign tax credit limits and carryovers.
• You live in Canada, where tax on pay is often high enough for the credit to cover the US tax: see Americans living in Canada.
• You are self-employed abroad: see self-employment tax abroad.
• Your old state may still tax you or ignore the exclusion: see ending state residency when moving abroad.
• Your spouse is not a US citizen or resident: see married to a nonresident.
• You want to amend several years, or fix excess IRA contributions over several years: get cross-border tax help.
• You still need to know whether to file and when: see filing while living abroad.