How to exclude foreign earned income from your US taxes
Have you heard that you don’t have to pay taxes on your foreign income? Sweet, huh?
But don’t get all excited and think that you don’t have to file tax returns and don’t have to pay any taxes. As almost everything in life and definitely everything related to taxes, it is not that simple.
It is true that certain foreign income can be excluded from taxes. It is called the Foreign Earned Income Exclusion or short FEIE. Let’s look at what this exclusion is, who can use it, and some other things you should know about it.
What is the Foreign Earned Income Exclusion?
The Foreign Earned Income Exclusion (FEIE) is the tax concept that is definitely worthwhile for US nomads to understand. Don’t be put off by the long name and acronym. You may be able to greatly reduce your federal taxes because it allows you to exclude income you earn while living and traveling abroad.
The thing is, there are some limitations. You can’t exclude everything and avoid all taxes.
Income limit
You can exclude up to $100.500 from federal income taxes for 2015. This limit is adjusted every year.
Not all income can be excluded
You can only exclude foreign income that you earn through work, like running a business, providing services or selling goods. If you have also investment income, for example a brokerage or savings account, that is not considered Foreign Earned Income and you cannot exclude that. You also cannot exclude retirement income.
Not all taxes can be avoided
The FEIE only cuts your personal income tax, not any other types of tax. If you are self-employed you still need to pay self-employment tax. If you are employed by a US company, you still have to pay social and employment taxes (half is paid by you, the other half by your employer).
State tax differs from federal tax
The FEIE applies to federal taxes. State tax may not allow it. For example California does not allow excluding foreign income and you may have to pay state income tax on your entire income.
Who can use the Foreign Earned Income Exclusion?
Not everyone who travels and earns an income abroad can just exclude $100k from their income taxes. You have to meet certain requirements to qualify for this exclusion.
There are basically two ways to qualify for the FEIE, the Physical Presence test and the Bona Fide Residency test.
The Bona Fide Residency test is very subjective and easily challenged by the IRS. It is also not very feasible for nomads who keep moving around as it requires you to establish residency in another country. So I will focus on the Physical Presence test.
The Physical Presence test basically comes down to counting days in foreign countries. You have to spend more than 330 full days in another country or countries in a 12 month period. It doesn’t matter in which or in how many other countries you spend those days. Here are the details
330 full days
Days that you travel into or out of the US or over International territory don’t count. Only entire full days that you spend in a foreign country can be counted towards the 330 days. Keep that in mind when you take that long cruise over International waters.
Full days are 24 consecutive hours starting at midnight.
The 330 days don’t have to be consecutive. You can go back to the US as often as you want, as long as you stay within the limit. But remember that travel days don’t count.
You can move from one foreign country to another without losing full days. But if any part of your travel takes you outside of foreign countries for 24 hours or more, you will lose full days. Examples are boat rides into International waters or transit stopovers in the US.
12 month period
The 12 months period does not have to be a calendar year. It can be any consecutive 365 day period.
You can chose any 12 months period that gives you the greatest number of days in foreign countries. 12 months periods can overlap, so you are not stuck with one selection for different tax years.
The IRS does a pretty good job explaining it here with examples.
You have to file a tax return to get the FEIE
You can only use the Foreign Earned Income Exclusion (FEIE) when you actually file a tax return. If you don’t file you can’t claim it and may even lose the right to use it. That means if the IRS catches you with unfiled tax returns, you may have to pay taxes on your entire foreign income plus late payment penalties.
Other things to know about the FEIE
If you exclude all you earned income, you can’t contribute to an IRA
If you want to save for your retirement in an IRA or Roth IRA account, which both have tax advantages, you need to have earned income. You can’t use investment income for IRA contributions. And you can’t use foreign earned income that you excluded using the FEIE.
You can get credit for income tax you paid in other countries
If you are a resident in another country and have to pay income taxes there, you can get a credit for the foreign tax you paid. But you can use that Foreign Tax Credit only on foreign income that you don’t exclude using the FEIE. So it is either excluding the foreign income from US taxes or offsetting US taxes with the foreign tax you already paid. As a rule of thumb, if taxes in your resident country are rather high, you might be better off using the Foreign Tax Credit. Consult a tax adviser.
