The foreign earned income exclusion allows U.S. citizens and residents to exclude a certain amount of their foreign earnings from U.S. taxation, promoting work abroad without the burden of double taxation. This exclusion is designed to prevent U.S. taxpayers from being taxed on income earned in a foreign country, which is already subject to foreign tax, ultimately encouraging international work and investment.
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For the tax year 2023, the maximum foreign earned income exclusion is $120,000 per qualifying individual.
To qualify for the exclusion, taxpayers must meet either the physical presence test or the bona fide residence test.
Taxpayers can also claim a foreign housing exclusion or deduction for certain housing expenses incurred while living abroad.
The foreign earned income exclusion does not apply to income earned as a government employee or as a military personnel member.
U.S. citizens and residents who exclude their foreign earned income cannot later use that excluded income to qualify for certain benefits like Social Security.
Review Questions
What are the criteria that must be met for a taxpayer to qualify for the foreign earned income exclusion?
To qualify for the foreign earned income exclusion, taxpayers must meet either the physical presence test or the bona fide residence test. The physical presence test requires individuals to be physically present in a foreign country for at least 330 full days during a 12-month period. Alternatively, the bona fide residence test requires that individuals establish residency in a foreign country for an uninterrupted period that includes an entire tax year.
How does the foreign tax credit complement the foreign earned income exclusion, and what advantages does each provide to taxpayers working abroad?
The foreign tax credit complements the foreign earned income exclusion by allowing taxpayers to offset their U.S. tax liability with taxes paid to a foreign government. While the exclusion helps avoid double taxation on foreign earnings by excluding them from U.S. taxable income, the credit provides relief for those who still have U.S. tax obligations after claiming the exclusion. Taxpayers can choose between these two benefits, depending on which option results in a lower overall tax burden.
Evaluate the potential impact of claiming the foreign earned income exclusion on an individual's future eligibility for Social Security benefits.
Claiming the foreign earned income exclusion can have significant implications for an individual's future eligibility for Social Security benefits because excluded income does not count towards Social Security credits. Since these credits are necessary to qualify for benefits, individuals who frequently claim this exclusion may find themselves lacking sufficient credits when they retire. This could affect their financial security in retirement, making it crucial for individuals considering international work to evaluate how this decision aligns with their long-term financial goals.
A tax form used by U.S. citizens and residents to claim the foreign earned income exclusion and the foreign housing exclusion.
Foreign Tax Credit: A credit that allows taxpayers to offset the amount of foreign taxes paid against their U.S. tax liability, helping to alleviate double taxation.
Bona Fide Resident Test: A test used to determine if an individual qualifies for the foreign earned income exclusion based on their residency status in a foreign country.