Foreign Tax Credit vs. Foreign Earned Income Exclusion: Which Is Better?

Should I claim the Foreign Earned Income Exclusion or the Foreign Tax Credit? is one of t most common questions.

There is not straight answer to this question.

I know that's probably not the answer you were hoping for, but choosing the wrong one can cost you thousands of dollars over time.

In my experience, many taxpayers automatically claim the Foreign Earned Income Exclusion only because it's the one they've heard about. In reality, the Foreign Tax Credit is often the better option, particularly for Americans living in higher-tax countries including EU.

The key is understanding how each one works.

What Is the Foreign Earned Income Exclusion?

The Foreign Earned Income Exclusion (FEIE) allows qualifying Americans living abroad to exclude a portion of their earned income from U.S. taxation.

To qualify, you generally must:

• Meet either the Physical Presence Test or Bona Fide Residence Test.

• Have foreign earned income.

• Maintain a tax home outside the United States.

The key word here is "earned", because only earned income qualifies. Earned income generally includes wages, salaries, bonuses, commissions, and income from self-employment or providing services.

Investment income, dividends, interest, capital gains, rental income, and most retirement income do not.

What Is the Foreign Tax Credit?

The Foreign Tax Credit (FTC) works differently.

Instead of excluding income, it allows you to claim a credit for income taxes paid to another country.

In simple terms, if you already paid tax to your country of residence, the IRS may give you credit for those taxes when calculating your U.S. tax liability.

Unlike the FEIE, the Foreign Tax Credit can apply to many different types of income, not just earned income.

One important consideration: neither the FEIE nor the FTC eliminates U.S. Social Security and Medicare taxes (self-employment tax).

Depending on the country where you live, a totalization agreement between the United States and your country of residence may help prevent paying into two social security systems on the same income.

Which One Is Better?

There is no universal answer.

That being said, I have noticed a pattern.

If you move to a country with relatively high income tax rates, such as Italy, France, Germany, or Portugal, the Foreign Tax Credit often produces a better overall result.

Why?

Because those countries frequently impose higher income taxes than the United States.

Those foreign taxes can often offset most, if not all, of your U.S. income tax.

On the other hand, if you move to a country with little or no income tax, the Foreign Earned Income Exclusion may become much more valuable.

It's Not Just About This Year's Tax Return

This is one area where I encourage people to think beyond the current year.

Choosing between the FEIE and FTC can affect:

• Future tax planning

• Foreign tax credit carryforwards

• Retirement contributions

• Child Tax Credit eligibility

• Future years after returning to the United States

In my experience, the decision should be viewed as part of a longer-term strategy rather than simply selecting whichever option produces the lowest tax this year.

Business Owners Need to Be Careful

If you own an LLC or S-Corporation, the analysis often becomes more complicated.

Many business owners assume they can simply exclude all of their business income under the FEIE.

That is not necessarily the case.

The interaction between business structures, reasonable compensation, self-employment taxes, foreign corporations, and foreign tax rules can significantly affect the outcome.

For entrepreneurs, this is one of the most valuable planning discussions before moving abroad.

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Can You Use Both?

Sometimes.

The Foreign Tax Credit and Foreign Earned Income Exclusion are not always mutually exclusive.

In certain situations, taxpayers may use both, although the interaction between the two can become quite technical.

The objective is usually not to maximize one benefit or the other. It is to develop the combination that produces the best long-term result.

So Which One Should You Choose?

If there were one answer that worked for everyone, international tax planning would be much easier.

The reality is that the best choice depends on:

• Your country of residence

• Your income level

• The type of income you receive

• Whether you own a business

• Local tax rates

• Your long-term plans

This is one of those decisions that is much easier to make before you establish foreign residency than after several years have passed.

If you are planning a move abroad or already living overseas, I would be happy to review your situation and help determine which approach makes the most sense for your circumstances.

Or schedule an International Tax Consultation to discuss your specific situation.