Foreign Tax Credit - the Preferred Anti Double Taxation Tool for American Expats
Expats who live and work abroad are used to the problem of double taxation. This is due to the fact that US citizens (and Green Card holders) are required to report their foreign income to the IRS as well as pay taxes to their country of residence.
There are two very useful aids for avoiding the problem of double taxation: the Foreign Earned Income Exclusion and the Foreign Tax Credit. These methods are both valuable, but under different circumstances. When faced with the choice - it is often more beneficial to use the Foreign Tax Credit alone; this article will explain the basics of this principle.
The Foreign Earned Income Exclusion (FEIE), Is It Beneficial?
In days gone by, the Foreign Earned Income Exclusion was every expat’s method for
avoiding double taxation. Especially since it was almost double the current amount in inflation adjusted terms (see graph). However, in 2006, President Bush signed the “Tax Reconciliation Act of 2005”. This eliminated the option of taking the massive deductions allowed by the FEIE ahead of other deductions and exemptions. The previous way of doing things had been hugely beneficial to high earning expats because it placed them in a lower tax bracket than they actually earned. Post 2006, it is often more advantageous to skip the FEIE and go strictly with the Foreign Tax Credit method of saving, however.
To be beneficial, the FEIE should only be used by Americans living in countries with either no income tax or an income tax rate that is lower than the American rate. You can check this page of our site for what your US Federal income tax bracket is. If an expat resides in a country with a tax rate that is the same or higher than the American rate, disadvantages follow use of the Foreign Earned Income Exclusion.
There is an important term that every expat must become familiar with. That term is Modified Adjusted Gross Income. This term becomes important for expats who are using or considering using the FEIE. With the exclusion, expats must add the excluded amount back into their adjusted gross income (AGI), making it a “modified” AGI.
Roth IRA and The Child Tax Credit
A ROTH IRA is a very valuable savings tool. One is allowed to contribute after tax dollars from taxable compensation in the amount of $5,000 ($6,000 for those who are 50 or over). Money deposited into a ROTH IRA can be invested freely or left alone to accrue interest that is completely tax free. However, if an expat has used the FEIE and has therefore excluded all of his income, he will have no taxable compensation to contribute to a ROTH IRA. Be warned!
The Child Tax Credit is a valuable tax savings tool for parents as it credits a taxpayer $1,000 per minor child if the taxpayer earns under a specified amount. In fact, it is possible to receive this credit as a refund even when the expat owes no tax, as long as the taxpayer can prove taxable earned income. If all of an expats earnings were excluded under the FEIE, he will lose the credit at $1,000 per child.
Excluding all earned income, which is common under the FEIE, will result in an inability to qualify for benefits like a ROTH IRA or the Child Tax Credit because these tools require reportable earned income. If an expat chooses to save via the Foreign Tax Credit, however, he will still report taxable earned income and will qualify for the aforementioned savings tools.
If an expats falls prey to the glimmering appeal of the FEIE, and then realizes after the fact that it was not beneficial under his circumstances, he will be allowed to retrace his taxes back to 2008 and file an amended return. Sadly, though, missed ROTH opportunities are gone forever.
The Exclusion and Foreign Tax Credit in Tandem
It is possible to use both the FEIE and the FTC in the same year. But using both while in a country whose tax rate is higher than that of the US is a waste of time and energy. It is absolutely possible to pay higher taxes by using the FEIE followed by the FTC than it would have been to use the FTC alone. The details are complex, however, and are the reason that international tax professionals are an invaluable resource for expats. When in doubt, and with foreign taxes there is almost always reason to doubt,contact a tax professional.
The Foreign Tax Credit (FTC)
The Foreign Tax Credit is useful for any American who has paid taxes overseas. The FTC does not obligate a person to prove residence in an overseas location. If a U.S. citizen works overseas or is involved in foreign investments, it is likely that he has paid taxes to a foreign government. If the tax rate of the foreign country is equal to or greater than the U.S. tax rate, the Foreign Tax Credit will successfully rid the expat of any U.S. tax obligation on that amount.
Simply put, by claiming the FTC the U.S. tax obligation is lowered by the amount paid to the foreign government. The qualifications are straightforward:
- Only income tax is credited.
- The credited amount cannot exceed the amount that would have been owed to the U.S. government. If the income tax paid to a foreign government far exceeds the amount of the credit (because the foreign tax rate far exceeded the US rate), the expat will forfeit that amount. The credit, however, can be carried into the future.
- Although they are foreign taxes, expats cannot claim a credit for taxes on:
- Excluded income (the Foreign Earned Income Exclusion, income from Puerto Rico and Possessions)
- Taxes Imposed By Sanctioned Countries (Cuba, Iran, Libya, North Korea, Sudan, Syria)
- Foreign mineral income
- International boycott operations
- U.S. persons controlling foreign corporations and partnerships who fail to file required information returns
- Foreign oil/gas extraction income
Foreign taxes that cannot be credited through Foreign Tax Credit method are still eligiible to be claimed as part of itemized deductions.
Expats should never assume that something that applies to them is in their best interest. A tax break that is advantageous to one expat may be detrimental to another. Case in point: many unstudied applications of the FEIE over the FTC. Allow your money and the special expat credits to work for you by seeking the expert advice of a studied international tax professional.
I.J. Zemelman, EA is the founder of Taxes for Expats