Many U.S. expats have learned to use and cherish the Foreign Earned Income Exclusion (FEIE), a provision in the U.S. tax code allowing workers to exclude up to $120,000 (for 2023) of their non-U.S. salary for Federal taxation. If nothing else, the FEIE stands out for its absolute simplicity in an otherwise endlessly convoluted tax code: anyone deriving income from a foreign employer can claim the FEIE by filing form 2555, and there are remarkably few exceptions and caveats. It is one of the few “breaks” that expats get in their otherwise needlessly complex financial lives, so it’s perhaps no surprise that it represents the go-to, default option for most U.S. taxpayers abroad when it comes to avoiding double taxation. For the majority of expats, claiming the FEIE each year will absolutely be the right thing to do. However, in this article I will consider some of the drawbacks of using the FEIE, and consider instances where claiming the FEIE may actually have hidden costs. Once these costs are factored in, the same taxpayer may actually find that claiming the FEIE is not the optimal tax strategy.
Hidden cost #1: Missing out on unused foreign tax credits
Interestingly, many expats who use FEIE don’t actually need it, and could use the mechanism of tax credits to avoid double taxation instead (claiming credits in one country for taxes paid in the other). Expats in high tax jurisdictions in particular probably pay enough in foreign taxes to fully offset any potential U.S. tax liability, even without excluding any income. Other higher income earners may also use a combination of the two approaches: the FEIE up to the statutory limit, and tax credits for the remainder of their income. The benefit of the tax credit approach is that any unused foreign credit can be rolled over for 10 years, and, therefore, may be used in the future to offset potential U.S. tax liability. While using foreign credits is not always easy (indeed many foreign tax credits end up expiring), certain situations such as moving to a low tax country, or using certain pension withdrawal strategies, may give rise to very attractive opportunities for an expat to capitalize on their unused foreign tax credits. Using the FEIE may reduce or completely eliminate these opportunities.
Hidden cost #2: Losing the ability to contribute to an IRA
Excluding your income from federal taxation sounds great, but if you exclude all of your income, you may be making yourself ineligible for IRA or Roth IRA contributions, which require the presence of employment income as the primary criterion for eligibility. As a result, you could be missing out on the opportunity for tax deferred or even tax exempt growth afforded by IRAs and Roth IRAs. The benefit of making such contributions will vary greatly depending on your personal circumstances and country of residence, and some expats may not benefit from them at all. For a more detailed discussion on IRA contributions for expats please refer to my previous article on the topic:
Hidden cost #3: not receiving refundable tax credits
For expat parents who may qualify for child care tax credits, using the FEIE may have another hidden cost: it will make you ineligible for the refundable portion of that credit. In practice, this could mean missing out on the opportunity to receive USD $1,400 per child annually paid to you in cash, due to specific tax rules making FEIE claimants ineligible for tax credit refunds. Filers who simply claim foreign tax credits are unaffected and remain fully eligible for this tax credit, including the refundable portion.
Given the drawbacks outlined above, it is clear that while the FEIE is intuitively attractive for its efficient and straightforward nature, careful analysis may reveal certain shortcomings that could very well prompt some expat taxpayers to reconsider its use in favor of the tax credit approach. Unfortunately, the IRS does not let taxpayers simply flip-flop between credits and the FEIE. Once the FEIE election is revoked, it cannot be claimed again for at least 5 years, and will require a specific written request and IRS approval to re establish.* For many taxpayers, that convoluted procedure alone may justify the added cost of using the FEIE, and in all cases it is clear that revoking the FEIE should only be done after very careful consideration and consultation with your accountant and advisor.
ABOUT THE AUTHOR
Syl Michelin, CFA®
US EXPAT FINANCIAL ADVISOR
Syl Michelin is a Chartered Financial Analyst and fee-only, fiduciary financial advisor who works with cross-border families and American expatriates.
You should always consult a financial, tax, or legal professional familiar about your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Past performance does not guarantee future performance. Future returns may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost.