How claiming the Foreign Earned Income Exclusion could impact on other areas in your tax return
Claiming the Foreign Earned Income Exclusion and Foreign Housing Exclusion can be beneficial for the majority of U.S. expats, and indeed result in no U.S. tax liability, but let’s look at ways it could impact on other areas of your tax return.
Foreign Tax Credits
Oftentimes if you live in a higher taxing foreign jurisdiction, you should have sufficient foreign tax credits to offset the US tax calculated on your foreign earnings without the need to claim the Foreign Earned Income Exclusion. However this may not always be the case e.g in the year of arrival or if you are in a lower tax bracket.
Regardless, if you choose to exclude foreign earned income on Form 2555, the IRS prevents you from offsetting tax with a foreign tax credit or deduction for taxes on the income you have already excluded.
Foreign tax credits which would have been claimed were it not for the Foreign Earned Income Exclusion are also backed out of your Foreign Tax Credit carry-forward position.
As the foreign tax credits are backed out at your highest effective tax rate, your foreign tax credit carryover position can be less than if you had not claimed the foreign earned income exclusion in the first place.
This means that you could lose valuable excess foreign tax credits which may be utilized in prior or later years. (Excess Foreign Tax Credits may be carried back one year or carried forward for ten years).
Child Tax Credits
If you exclude foreign earned income using the Foreign Earned Income Exclusion, the excluded amount must be added back to your adjusted gross income when computing the eligibility for the credit – read my blog here about how the Foreign Earned Income Exclusion can impact on claiming refundable child tax credits.
Effective Tax Rate
Special rules determine the tax liability of individuals who exclude any amount from gross income by claiming the Foreign Earned Income Exclusion. These rules impose a “stacking” principle and could therefore raise the effective rate of tax on other non earned income. i.e before calculating your effective tax rate the excluded income is added back!
Bottom line – to claim or not claim the Foreign Earned Income Exclusion is not always a straightforward decision. At USTaxGlobal, we will always optimize your U.S tax position to see if it’s more beneficial to claim the foreign earned income exclusion, taking into account your individual facts and circumstances.