Americans living abroad have to file US taxes, reporting all of their worldwide income, regardless where in the world they are or where their income originates or is paid.
Many expats struggle to understand this requirement, especially seeing as most other countries only tax residents and income accrued in the country.
The US tax system is different however, and while the requirement for US citizens to file US taxes from abroad has existed since the Civil War, it’s the more recent US global economic dominance that has allowed the IRS to enforce US tax filing rules for expats, so that being abroad means being ‘under the radar’. US tax treaties don’t prevent expats from having to file, either.
The IRS has provisions that expats can claim when they file to reduce their US tax bill though, often to zero.
What is the Foreign Earned Income Exclusion?
The Foreign Tax Credit is the primary provision that allows expats to avoid double taxation. By filing Form 1116, expats can claim US tax credits worth the same value is US dollars as foreign taxes they have paid.
The Foreign Earned Income Exclusion is an alternative provision that allows expats to reduce their US tax bill regardless of whether they pay foreign income taxes or not.
It allows Americans who meet the qualifying criteria to exclude just over $100,000 of their earned income from US taxation.
The exact threshold rises with inflation each year. For 2020, it’s $107,600 of earned income, for 2021, it’s $108,700.
Who is it for?
Expats often wonder whether they should claim the Foreign Earned Income Exclusion or the Foreign Tax Credit.
The answer depends on several factors.
The Foreign Earned Income Exclusion best suits Americans whose only income is earned (as opposed to unearned, passive income such as from investments, social security, retirement income, dividends, or rental income), and whose total income is below the annual exclusion limit.
A further consideration that often makes the Foreign Earned Income Exclusion a good option is if an American abroad doesn’t pay at least the same amount of foreign income tax as they would owe the US. If they do, it normally makes more sense to claim the Foreign Tax Credit.
Whether expats have dependent children with US social security numbers can be another determining factor, as it’s difficult to claim both the refund for the Child Tax Credit and the Foreign Earned Income Exclusion.
Many international digital nomads benefit from claiming the Foreign Earned Income Exclusion, if they’re traveling from country to country.
If you’re not sure which is the best way to reduce your US tax bill when filing from abroad, it’s best to consult a US expat tax specialist.
How to claim the Foreign Earned Income Exclusion
To claim the Foreign Earned Income Exclusion, expats must file IRS Form 2555 along with their Form 1040.
Form 2555 asks for confirmation that your tax home is in a foreign country. This means that the place where you work from is abroad, regardless where (or in what currency) you are paid.
You can either provide confirmation by having permanent residency in another country (this is called the Bona Fide Residence Test), or by proving that you spent at least 330 days outside the US over 365 days (normally but not necessarily the tax year; this is called the Physical Presence Test).
Can you claim the Foreign Earned Income Exclusion in retrospect?
Americans living and working abroad who have missed one or more US tax filings can normally catch up and claim the Foreign Earned Income Exclusion in retrospect as long as the IRS hasn’t contacted them about their missed filing yet.
Expats who have missed more than two filings may qualify to catch up without facing penalties under the Streamlined Procedure amnesty program.