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10 July 2016

US taxpayers working and living abroad may qualify for the Foreign Earned Income Exclusion. I won’t get into how one qualifies for it here – that’s a whole different set of (highly complex) rules. Suffice it to say you essentially have to be working out of the United States for a year before it starts to become a possibility.

It’s a really good tax benefit, but not as good as I think it should be. I’ve completed the tax returns for several people who claimed it in 2015, and it’s never quite as good as they think (or hope) it will be either. There are two main reasons for that, and they are somewhat complicated. I’m going to break those two reasons down and make them easier to understand.

Reason #1: The Way the Cap is Figured.

The amount of foreign earned income that can be excluded from your income for tax purposes is capped. In 2015 it was $100,800. The maximum amount is indexed for inflation, so it goes up every year. The issue here is the cap is also limited by the amount of time you actually worked in a foreign country during the year. The only way to get the full $100,800 exclusion is to be in the foreign country all 365 days of the tax year. That’s not very common.

Let’s say a person worked in a foreign country from July 1, 2015 until June 30, 2016, and they meet the requirements to qualify for the Foreign Earned Income Exclusion. That span covers two tax years. The foreign earned income received from July 1 – December 31, 2015 goes on the 2015 tax return. The foreign earned income received from January 1 – June 30, 2016 goes on the 2016 tax return. This person earned $100,000 from July 1 – December 31, 2015. That’s below the 2015 cap of $100,800 for the Foreign Earned Income Exclusion, but that entire $100,000 cannot be excluded – even though it was all foreign earned income.

We have to apply the ratio of days in 2015 in the foreign country to the amount of foreign earned income to determine how much can be excluded.

From July 1 – December 31 is 184 days.

184/365 = .504 (the tax code has us round to 3 places)

.504 X $100,800 = $54,432

The maximum amount this individual can exclude as foreign earned income in 2015 is $54,432 - well below the $100,000 they earned overseas.

Reason #2: The Way The Tax Is Calculated

The second reason this tax benefit isn’t as good as it could be is the IRS uses a special calculation to figure the tax on income that is reduced by Foreign Earned Income Exclusion. It’s right there on page 42 of the 2015 Form 1040 Instructions: If you claimed the foreign earned income exclusion, housing exclusion, or housing deduction on Form 2555 or 2555-EZ, you must figure your tax using the Foreign Earned Income Tax Worksheet. Below is the important part of that worksheet:

Virginia Beach Tax Preparation Foreign Earned Income Worksheet

Essentailly the worksheet has you add the foreign earned income back to your taxable income. Then you find the tax on that amount. Then you find the tax on the amount of the excluded foreign income and subtract that amount from the tax on the total.

This matters because the IRS is not treating this excluded income like a deduction. Deductions come off the top of your income, and you receive the tax benefit at your top marginal rate. What this fancy little worksheet does is rearrange things to take the Foreign Earned Income Exclusion off the bottom of your income. Your tax savings come at your lowest marginal rates instead of your highest marginal rates.

That’s a bit of a tough concept to comprehend, so I made some graphics that I hope will clarify it for you. We will stick with the numbers from the first example. Our hero – the taxpayer – made $100,000 in 2015, of which $54,432 qualifies for the Foreign Earned Income Exclusion. We exclude that from his income. Let’s also assume that through other deductions and exemptions his taxable income on line 43 comes to $30,000. We’ll also make him single and use the tax rates for taxpayers filing as single.

First, let's look at the marginal tax rates for a single taxpayer in 2015:

Virginia Beach tax preparation tax rates 2015 single2

Now let's take a look at a graphic showing the difference between his foreign earned income being treated as a regular deduction (How it should be) vs the way the Foreign Earned Income Tax worksheet treats the Foreign Earned Income Exclusion (How it is):

Virginia Beach tax preparation foreign earned income tax break2

The left side shows the taxpayer's total taxable income stack next to the tax rates chart. When we exclude the foreign earned income from the top (as if it were a normal deduction) the remaining $30,000 of income is taxed at the lowest tax rates.

The right side shows nearly the same thing, except that the foreign earned income is excluded from the bottom of the income stack. That leaves the remaining $30,000 being taxed at the taxpayer's highest rates.

If that seems insignificant, it is not. If the taxpayer could just figure his tax on the $30,000 as if the foreign earned income was treated like a deduction (How it should be), then his tax bill would be $4,043. By using the worksheet and taking the Foreign Earned Income Exclusion off the bottom (How it is) the taxpayer has a tax bill of $7,500. A difference of $3,457. That little Foreign Earned Income Tax Worksheet calculation creates an 85.5% increase in the taxes owed by the taxpayer!

Don't get me wrong - it's still a HUGE tax benefit to use the Foreign Earned Income Exclusion. Without it our hero's tax bill would have been $16,900 instead of $7,500. How it is still reduced the tax burden by $9,400 for this taxpayer. That's significant money. It just irks me that our government comes up with this additional way to calculate the tax that prevents the benefit from being as good as it could be. (With the added bonus of making the tax calculation nearly incomprehensible to most taxpayers.)

On a happier note - Virginia doesn't bother with this fancy calculation for state tax returns. Like many states, Virginia's state income tax calculation begins with the Federal Adjusted Gross Income. Since the foreign earned income is removed prior to the federal AGI calculation, that income never even makes it onto the Virginia tax return. In essence, it has come off the top for Virginia tax purposes.

If you qualify for the Foreign Earned Income Exclusion, make sure you are using it.  If you have questions about the Foreign Earned Income Exclusion please contact me.

Disclaimer

Information in the Tax Blog is current as of the day it was posted. Tax laws change frequently, and it is likely that as time passes acts of Government will make some of the older blog content out of date.

The information provided is for education purposes only. It is general in nature and may not pertain to the Reader's situation. Every taxpayer's circumstances are unique. Reader's are urged to do some research or talk to a tax professional before acting on any of the information posted in this blog.

Paul D. Allen is a proud member of the National Association of Enrolled Agents, the National Association of Tax Professionals the Financial Planning Association of Hampton Roads, the National Association of Personal Financial Advisors (NAPFA), and The Tidewater Real Estate Investors Group. You can read more about Paul's background here.

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Common Acronyms

ACTC - Additional Child Tax Credit

AGI - Adjusted Gross Income

AMT - Alternative Minimum Tax

APTC - Advanced Premium Tax Credit

AOC - American Opportunity Credit

CTC- Child Tax Credit

EIC - Earned Income Credit

HoH - Head of Household

LLC - Lifetime Learning Credit

MFJ - Married Filing Jointly

MFS - Married Filing Separately

MAGI - Modified Adjusted Gross Income

PIM - Plan of Intended Movement

PTC - Premium Tax Credit

QC - Qualifying Child

QHEE - Qualifying Higher Education Expenses

QR - Qualifying Relative

QW - Qualifying Widow(er)

 

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