We notice that many expats claim the Foreign Earned Income Exclusion (‘FEIE’) over the Foreign Tax Credit (“FTC”). While the FEIE is usually the only expat tax break available for expats who live in countries that do not levy local income tax, we want to demonstrate why claiming the FTC, where possible, is much more advantageous than claiming the FEIE.
If you are not familiar with these expat tax breaks, we recommend first reading our basic article on expat taxes.
When to claim the FEIE and when to claim the FTC?
The Foreign Earned Income Exclusion is only beneficial for expats who live and work in a country with no income tax (e.g., the United Arab Emirates), or in a country with a lower income tax rate than the US (e.g., Singapore). Let’s illustrate this with two examples:
Example – when to claim the FEIE
Pat has a 5 year assignment in Hungary which has a 10% tax rate. As Pat paid tax in Hungary, Pat is eligable to claim the FTC. However, the FTC is likely to be less beneficial than the FEIE, as the Hungarian rate is lower than the US rate. In this scenario, the Hungarian taxes that Pat paid cannot offset the US taxes Pat would owe, and therefore it is generally better for Pat to claim the FEIE.
When expats live and work in a country with the same or higher tax rate than the US tax rate, you should claim the FTC as the FEIE will bring disadvantages. This will be illustrated further with the help of examples. It is as simple as that!
Example – when to claim the FTC
Pat has a 5 year assignment in the Netherlands which has a 40% tax rate. As Pat paid tax in the Netherlands, Pat should be eligable to claim the FTC. In this scenario the FTC can be more beneficial than the FEIE as the Dutch tax rate is higher than the US rate, therefore the Dutch taxes that Pat paid can offset the US taxes entirely that Pat would owe, and therefore it is better to claim the FTC.
Reason #1 – simplicity!
Filing form 1116 (FTC) has a lot less information and foreign residency requirements compared to filing the Form 2555 (FEIE):
- Form 2555 (FEIE) requires a lot of information about an expat’s foreign employer, address, time abroad, family, etc. This can be very tedious, especially when counting travel days!
- Form 1116 (1116) does not require such information. This means that you can complete your expat tax return significantly faster when you claim the FTC and file Form 1116, as compared to claiming the FEIE and filing Form 2555.
- Form 2555 (FEIE) can only be used when an expat taxpayer fulfills several strict requirements. For example, you need to check whether you meet the Physical Presence Test or the Bona Fide Residence Test. If you choose to claim the FTC, these tests are irrelevant, and therefore counting days abroad is also no longer needed!
Reason #2 – if you have dependents, you may get a refund!
US expats who claim the FEIE are ineligible to claim the Additional Child Tax Credit (‘ACTC’). The Additional Child Tax Credit is a refundable credit of up to $1,400 per child (2019 amounts).
However, claiming the FTC allows expats to still claim the Additional Child Tax Credit, creating a bigger refund! Let’s illustrate this with an example:
Pat lives in the Netherlands and earns $100,000 and has paid on average of 42% Dutch income tax rate. The US has a lower income tax rate than the Netherlands, so Pat will be able to claim the FTC and completely offset any US tax bill on their foreign income, and end up owing no US taxes. Pat also has a son Nick, making Pat eligible for the ACTC. However, Pat could also claim the FEIE and end up owing no US taxes as well.
In both scenarios (FTC and FEIE), Pat is able to claim an expat tax break and owe no US taxes. However, if Pat claims the FTC, Pat will expect a refund of $1,400. Meanwhile, if Pat claimed the FEIE, Pat would not get a refund!
In this example, Pat is better off claiming the FTC and getting a refund as compared to claiming the FEIE and not getting anything!
Reason #3 – flexibility!
Once you claim the FEIE, you are stuck with this election for 5 years. If you claim the FEIE in one year, and then claim the FTC in another year, the IRS will consider your election to claim the FEIE “revoked”. What this means, is that if you want to claim the FEIE again within 5 years then you need to request and receive special permission from the IRS before doing so, this is a tedious and expensive process to do so.
Reason #4 – excess tax credits for future years!
In countries that levy income taxes at a rate higher than the US, expats can use the FTC to offset any US tax liability, while building up an FTC carryforward to use in future years! Unused FTCs can be carried forward for 10 years!
Pat lives and works in Germany and makes $100,000 in year 1. She paid $40,000 in German taxes, and would have owed $15,000 in US taxes. However, Pat decided to claim the FEIE and all of her foreign income was excluded from US tax.
At the end of year 1 Pat receives on offer to work in Dubai for a salary of $150,000. Dubai does not have any income taxes. Pat decides to take this job and starts working in Dubai in year 2.
Pat decided to file her US expat taxes in year 1 by claiming the FEIE. Now that Pat lives in Dubai in year 2, she is not subject to tax (UAE does not levy an income tax). As Pat chose the FEIE in year 1, Pat also needs to claim the FEIE for her US expat tax return in year 2. The FEIE allows an exemption of up to $105,900 (2019 amounts), meaning that Pat is subject to US income tax on the remainder of her income above the excluded $105,900 amount.
If Pat decided to claim the FTC in year 1, instead of the FEIE, she would have built up an FTC carryforward. What this means is that the excess of her German taxes over the US taxes owed can be used by Pat in future years. In the example above, Pat would have had an FTC carryforward of $25,000 ($40,000 taxes paid in Germany, less $15,000 credit used against US taxes owed).
This FTC carryforward of $25,000 would be available for Pat in year 2 and offset any remaining US taxes owed on her income above the excluded $105,900 amount! Poor Pat!
Reason #5 – IRA and 401k accounts!
Claiming the FEIE precludes expats from contributing to tax priveliged retirement accounts, such as employer sponsored 401ks, Roth, and Traditional IRAs, from amounts that are excluded by the FEIE. Contributing to such accounts with income excluded using the FEIE can lead to penalties and interest.
However, no such rule exists if an expat claims the FTC instead. Therefore, expats claiming an FTC can still participate in such retirement accounts!
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