Tax Credits vs. Deductions: What’s the Difference & Which are Better for Expats

As a US expat, you’re likely drowning in a sea of tax complexity. You’ve heard about tax credits and deductions, but you’re not sure which applies to your unique situation or how to use them effectively.

This confusion isn’t just frustrating—it could be costing you thousands of dollars each year. Are you missing out on sizable tax savings? Could you be reducing your US tax bill even further? Without a clear understanding of credits and deductions, you might be leaving money on the table or, worse, facing potential penalties for incorrect filings.

We’re here to simplify things. In this guide, we’ll clarify the difference between tax credits and deductions for expats, explore how they differ, and help you understand which options might be best for your situation. You’ll have a clearer picture of how to optimize your tax strategy and feel confident when US tax filing season arrives.

Tax credits explained

Tax credits offer direct reductions to your tax bill. They can be a powerful tool in your tax-saving arsenal and a key strategy for savvy expats looking to optimize their tax situation.

Here’s where tax credits really shine: they work on a dollar-for-dollar basis. Owe $5,000 in taxes but have a $1,000 tax credit? Your bill instantly drops to $4,000. It’s that straightforward and effective.

Types of tax credits

1. Refundable credits: These credits can reduce tax liability below zero, resulting in a refund in the form of a check from the IRS to you. For example, if you owe $500 in taxes and have a $1,000 refundable credit, you’ll receive a $500 refund.
2. Nonrefundable credits: These credits can reduce tax liability to zero but won’t produce a refund. With a $500 tax bill and a $1,000 nonrefundable credit, your tax liability becomes zero, but you don’t receive the excess $500.

What are some expat-friendly tax credits?

1. Foreign Tax Credit (FTC): This credit is a lifesaver for many expats, especially those residing in high-tax foreign countries. It provides a dollar-for-dollar reduction based on taxes paid to foreign governments, potentially significantly lowering your US tax burden.
2. Child and Dependent Care Credit: If you’re a working parent, this credit covers up to 35% of your qualifying childcare expenses, maxing out at $3,000 for one child or $6,000 for two or more. Remember, your childcare provider can’t be your spouse or a dependent.
3. Additional Child Tax Credit (ACTC): For parents, this credit can be a game-changer, offering up to $2,000 per eligible child under 17. Take note: it requires earned income and can’t be combined with the Foreign Earned Income Exclusion, according to the IRS.

Let’s illustrate this with a real-life example: You’re an expat in Germany, earning $87,000 and paying $21,800 in German taxes. Your US tax liability is $15,000, but you can claim the entire amount as a FTC, reducing your US tax bill to zero. Although you have two children and spend $8,000 on childcare, you won’t benefit from the CTC or CDCC because your US tax liability is already zero after applying the FTC.

Tax deductions explained

Tax deductions reduce your taxable income before calculating the tax you owe. While not as directly impactful as tax credits, deductions can still lead to significant savings, especially if you’re in a higher tax bracket.

Example: If you’re in the 24% tax bracket and you have a $1,000 deduction. That deduction doesn’t reduce your taxes by $1,000, but it does lower your taxable income by $1,000, which saves you $240 in taxes.

Types of tax deductions

1. Standard deduction: For the 2024 tax year, the standard deduction is $14,600 for single filers and $29,200 for married couples filing jointly. It’s a flat amount that reduces your taxable income, no questions asked. All taxpayers, including expats, are eligible to use this deduction to reduce their taxable income
2. Itemized deductions: An alternative to the standard deduction. To determine whether itemizing deductions makes sense for you, start by listing all your eligible expenses. If these add up to more than the standard deduction, you’re in luck – you can potentially save more on your taxes by using this approach

Tax exclusions explained

Tax exclusions allow expats to exclude certain types of income from their US tax return, which can significantly reduce their tax liability. The specific eligibility requirements and amounts vary depending on the exclusion and the expat’s circumstances.

For example, a US citizen working in France could be eligible to exclude up to $120,000 of their foreign-earned income from their US tax return for tax year 2023.

Types of tax exclusions

1. Foreign Earned Income Exclusion (FEIE): For the 2024 tax year, you can exclude up to $126,500 of your foreign earnings from US taxes (an increase compared to $120,000 for the tax year 2023). But remember, you need to meet either the Physical Presence Test or the Bona Fide Residence Test to qualify.
2. Foreign Housing Exclusion/Deduction (FHE/FHD): This deduction lets you either exclude (for employees) or deduct (for the self-employed) a portion of your housing costs from your taxable income. The amount varies based on your location, but it can be substantial. For instance, if you’re living in a high-cost city like Hong Kong or London, you could be looking at a sizeable deduction.
3. Itemized deductions: Even as an expat, you can still claim itemized deductions if they exceed your standard deduction. Some common ones include:
   1. Charitable contributions: Donated to a US-based charity while abroad? That could be deductible.
   2. Mortgage interest: If you’re paying a mortgage on a home back in the States, you might be able to deduct the interest.
   3. State and local taxes: There’s a cap of $10,000, but hey, every bit helps!

Here’s a practical example: Say you’re a single expat living in Germany, earning $150,000. You qualify for the FEIE, immediately reducing your taxable income to $23,500. If you paid $15,000 in housing costs that qualify for the Foreign Housing Exclusion, you could potentially reduce your taxable income even further to $8,500. That’s a dramatic difference from your initial $150,000!

Key differences between credits and deductions

Understanding the primary differences between tax credits and tax deductions can be critical for your expat tax strategy:

Aspect	Tax credits	Tax deductions
Impact on tax Liability	Direct dollar-for-dollar reduction of tax bill	Reduce taxable income; impact depends on tax bracket
Calculation method	Flat amount or percentage of expenses up to a limit	Subtracted from taxable income
Example	Child Tax Credit: up to $2,000 per qualifying child	FEIE: subtract up to $126,500 (2024) from foreign earned income
Common uses for expats	Foreign Tax Credit, Child Tax Credit	Foreign Earned Income Exclusion, Foreign Housing Exclusion/Deduction
General advice	Usually preferable when available, due to direct impact	Can be more beneficial in certain high income or high foreign-tax situations

Which is better for expats: credits or deductions?

This is a crucial consideration for anyone living abroad, so let’s break it down with some real-world scenarios.

Factors to consider

• Individual tax situation: Every expat’s situation is unique. Your marital status, number of dependents, types of income, and even your future plans can all impact which option is best.
  • Example: A single expat with no children might benefit more from the Foreign Earned Income Exclusion (a deduction), while a married expat with multiple children might find the Foreign Tax Credit combined with the Child Tax Credit more advantageous.
• Host country tax rates: The tax rates in your country of residence play a significant role in determining whether credits or deductions are more beneficial.
  • Example: If you’re living in a high-tax country like Denmark or France, the Foreign Tax Credit might be your best bet. However, if you’re in a low-tax or no-tax country like the UAE, the Foreign Earned Income Exclusion could be more beneficial.
• Income levels: Your income level can significantly influence which option is best, especially given the caps on certain deductions and credits.
  • Example: If your income exceeds the Foreign Earned Income Exclusion limit ($126,500 for 2024), you might find a combination of the FEIE and Foreign Tax Credit most beneficial.

When credits may be more beneficial	When deductions/exclusions may be more beneficial
High-tax countries: If you’re paying more in foreign taxes than you would owe to the US, the Foreign Tax Credit can eliminate your US tax liability and potentially give you excess credits to carry forward.	Low-tax or no-tax countries: The Foreign Earned Income Exclusion can be particularly valuable if you’re living in a country with lower tax rates than the US
Families with children: The Child Tax Credit can be valuable if you have US tax liability after applying the Foreign Tax Credit.	Expensive locations: The Foreign Housing Exclusion/Deduction can be beneficial in expensive cities, especially when combined with the FEIE.
Passive income earners: If your income consists of passive income such as investments, or rental income, the Foreign Tax Credit will be more relevant and helpful to you than the Foreign Earned Income Exclusion
IRA Contributers: Those who wish to contribute to a US tax deferred retirement account such as a Traditional or Roth IRA may find the Foreign Tax Credit a better option, allowing them to continue to make contributions.

Remember: These are general scenarios, and the best choice can vary based on individual circumstances. It’s often beneficial to calculate your tax liability using both methods to determine which is more advantageous. In some cases, a combination of credits and deductions might be the optimal strategy.

Here’s a practical example tying it all together:

Jack is an American expat in Japan earning ¥10,000,000 (about $90,000) and paying ¥2,000,000 (about $18,000) in Japanese taxes.

• Tax credit scenario: Jack can claim the FTC for the $18,000 paid to Japan, directly reducing his US tax bill by that amount.
• Tax deduction scenario: Alternatively, Jack could use the FEIE to deduct $90,000 from his taxable income. If he’s in the 24% tax bracket, this would save him $21,600 in taxes.

In this case, the deduction (FEIE) actually saves Jack more money than the credit (FTC). This illustrates why it’s crucial to run the numbers both ways!

Pro tip: Use tax software designed for expats or consult with an expat tax specialist. The calculations can get complex, especially when dealing with foreign currency conversions and exclusions.

Make the right choice with Bright!Tax

Both tax credits and deductions are valuable tools for reducing your tax burden. Understanding how they work and when to use each can help you maximize your tax savings.

Tax laws can be complex, especially for expats. Consulting with a qualified tax professional can ensure you’re taking advantage of all available tax benefits and avoiding costly mistakes.