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Tax Guide
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Foreign tax credit: The preferred anti double taxation tool for American expats

Foreign Tax Credit

Expats who live and work abroad are used to the problem of double taxation. This is because U.S. citizens and permanent residents (also known as 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 ways you can avoid the problem of double taxation: the Foreign Earned Income Exclusion and the Foreign Tax Credit. Both methods are valuable, but there may be times when it is 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 still beneficial?

The Foreign Earned Income Exclusion (FEIE), Is It Beneficial?

Before the passage of the Tax Increase Prevention and Reconciliation Act (TIPRA) in 2006, the Foreign Earned Income Exclusion was the preferred method for avoiding double taxation. As you can see in the graph above, the maximum exclusion has steadily declined since the 1980s, bottoming out in 2006.

TIPRA eliminated the option of taking FEIE deductions ahead of other deductions and exemptions. While the old system allowed high-income expats to be placed in a lower tax bracket, after 2006, it is often more advantageous to skip the FEIE and to use the Foreign Tax Credit instead.

To be beneficial, the FEIE should be used by Americans living in countries with either no income tax or an income tax rate that is lower than the American rate. If you reside in a country with a tax rate that is the same or higher than the American rate, you may be better off without the FEIE.

Modified adjusted gross income (MAGI)

Every expat must be familiar with their Modified Adjusted Gross Income (MAGI), especially if they regularly use or are thinking of invoking 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. For the 2021 tax year, one is allowed to contribute up to $6,000 tax-free, or $7,000 for those who are 50 or over). Money deposited into a ROTH IRA can be invested freely or left alone to accrue completely tax-free interest. However, if an expat has used the FEIE and has therefore excluded all of their income, they 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 $2,000 for each child dependent under 17 if the taxpayer earns under a specified amount. It is also 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. However, if all of an expat's earnings were excluded under the FEIE, they will lose the child credit.

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, they will still report taxable earned income and will qualify for the aforementioned savings tools.

If an expat falls prey to the glimmering appeal of the FEIE and then realizes after the fact that it was not beneficial under their circumstances, they will be allowed to retrace their taxes and back file an amended return. Unfortunately, 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 U.S. is a waste of time and energy. You may 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 a 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, they have likely 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 eliminate any U.S. tax obligation on that amount.

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 U.S. 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 the Foreign Tax Credit method are still eligible to be claimed as part of itemized deductions.

Foreign taxes that cannot be credited through the Foreign Tax Credit method are still eligible to be claimed as part of itemized deductions.

A final word

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: the 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.