US citizens and permanent residents are taxed on worldwide income, regardless of where they live in the world. Fortunately, there are two common methods that US expats utilize to eliminate or lower US taxes on income earned abroad. The first is the foreign earned income exclusion, which allows one to exclude up to roughly $100K in foreign income. The second method is foreign tax credits (FTC), which is the main topic of this article.
Frequently, US expats and dual citizens erroneously use the foreign earned income exclusion, when they should have utilized foreign tax credits. Before we jump into the nuts and bolts of the FTC, it’s worth stating that the application of foreign tax credits is somewhat complicated. However, a thorough understanding of the FTC may have a BIG $$$ impact on your finances. With that introduction, let’s dive into the topic of optimizing foreign tax credits on a US tax return.
The FTC exists to provide relief from double taxation. Income taxes paid to a foreign country can be used to offset US taxes. In our opinion, there are 3 important factors to consider when deciding between foreign tax credits and the foreign earned income exclusion.
1. Effective tax rate in the foreign country vs. the rate that would apply in the US
2. Whether there is income in both a foreign country and the US
3. Whether there are children in the household
(1) Effective tax rate in the foreign country vs. the rate that would apply in the US.
Generally speaking, if you are paying a higher tax rate in the foreign country than you would under the US system, it’s better to utilize foreign tax credits. Foreign taxes paid often eliminate any US tax liability. The difference between foreign taxes paid and the US tax amount results in foreign tax credits that are carried forward (i.e. can be used in subsequent years).
Alternatively, if you are paying a lower tax rate in the foreign country than you would under the US system, then the foreign earned income exclusion should be exercised. If one has income above the $100K limit, then both the foreign earned income exclusion and foreign tax credits should be utilized. A pro-rated amount of foreign tax credits can be applied to the income above the exclusion limit.
(2) Whether there is income in both a foreign country and the US.
When a US person has income in both a foreign country and the US, the decision to utilize foreign tax credits should be based on the proportion of foreign to US income. That is because a number of foreign tax credits one can utilize will be limited by the % of foreign income to total income. For example, if a person has only foreign income, then he or she can apply 100% of foreign taxes paid toward the US tax liability. However, if the split of foreign to US income were 50/50, then the maximum amount of foreign tax credits one can utilize is limited to 50% of the US tax liability. Bottom line: utilizing foreign tax credits is advantageous when most of one’s income is derived from foreign sources.
(3) Whether there are children in the household
When there are children (under the age of 17) in the household, most US expats may be able to claim the child tax credit – a refund check from the IRS worth up to $1000 per child. Unfortunately, this credit can no longer be used to claim a refund when the foreign earned income exclusion is utilized on a tax return. However, the refundable child tax credit is still applicable when utilizing foreign tax credits. Therefore, there can be situations where utilizing foreign tax credits may create taxable income (vs. the foreign earned income exclusion); however, the applicability of the child tax credit will more than offset the taxable income, resulting in a refund. The following is an illustration of the rough math involved.
Julia and John each earn $25K in foreign wages. They are both US citizens and have 3 children under the age of 17 (all of whom have Social Security #s). From the $50K in combined wages, Julia and John paid only $1K in foreign taxes.
Based on the math, it is clearly in Julia and John’s interest to utilize foreign tax credits on their tax return vs. the foreign earned income exclusion. Often times, it is advisable to amend prior year tax returns to claim refunds that were missed. The aggregate refund amount can be surprisingly sizeable.
In summary, many US expats ignore foreign tax credits and utilize the foreign earned income exclusion because of simplicity. However, foreign tax credits can be very advantageous depending on one’s circumstances. Don’t let a little bit of complexity undermine your finances.
For more information on the foreign tax credit and other tax-related topics, visit us at holaexpat.com.
This article was written by John Ohe – IRS Enrolled Agent and CFA.
John works at Hola Expat, which specializes in tax services for U.S. expats.
If you would like to submit a question, email: [email protected]
Disclaimer: The facts provided in this article are for general information, and should not be construed as financial advice. Tax laws and regulations change frequently, and their application can vary widely based on the specific facts and circumstances involved.