The Foreign Tax Credit
As an American, you’re subject to US income taxation, even if you live abroad. Therefore, you’re required to file a US tax return and report your worldwide income to the IRS. However, you would generally also be required to file a tax return in the country where you live. The Foreign Tax Credit is designed to prevent taxpayers from being taxed twice on the same income.
What is the Foreign Tax Credit?
The basic idea behind the Foreign Tax Credit is to allow US taxpayers to reduce their US tax liability by the amount of income tax paid to the country where they live. The Foreign Tax Credit is subject to certain limitations. For example, the amount you’re allowed as a credit cannot exceed the tax amount you would have owed the IRS without the credit.
The Foreign Tax Credit and the Foreign Earned Income Exclusion
In addition to the Foreign Tax Credit, there is another important provision in the Internal Revenue Code that allows US expats to reduce their US tax liability. The Foreign Earned Income Exclusion allows you to exclude foreign earned income from your US taxable income.
Deciding whether to claim a Foreign Tax Credit or use the Foreign Earned Income Exclusion depends on your individual circumstances and the specifics of your income and tax situation.
Generally, the FEIE is more advantageous if you live in a country where the tax rates are lower than those in the US. However, the FEIE allows you to exclude ‘earned income’ only. Earned income includes wages and self-employment income. It does not include pensions, and passive income such as dividends, interest, etc. The maximum amount you’re allowed to exclude for tax year 2023 is $120,000. The amount is adjusted for inflation annually. To qualify for the FEIE you must either meet the ‘bona fide residence test’ or the ‘physical presence test’.
You can claim a credit for foreign taxes paid on passive income and other unearned income.
Who Should Claim the Foreign Tax Credit?
If your foreign income is subject to foreign taxes at rates that are higher than those in the US, claiming the foreign tax credit would generally be more beneficial.
For example, let’s say you live in France and your French wages are $10,000. You’re subject to tax in France on your French wages and you owe the French tax authorities $2,500. As an American, you’re required to report your French wages to the IRS. Let’s assume you would have owed the IRS $2,000 had you lived in the US and earned $10,000. The part of the $2,500 that you paid to the French tax authorities and that’s allowed as a credit on your US tax return is limited to the $2,000 you would have owed the IRS without the credit. The difference ($500) is your ‘excess foreign tax credit’. It can be carried back or carried forward to other tax years, subject to limitations.
What If I’d Like to Contribute to my Roth IRA?
You can claim the Foreign Earned Income Exclusion and contribute to your Roth IRA, as long as you meet the eligibility requirements for both. Contributing to a Roth IRA is not directly affected by claiming the Foreign Earned Income Exclusion. As long as you have eligible earned income, whether foreign or domestic, you can contribute to your Roth IRA. In other words, if you’re excluding all of your earned income by claiming the FEIE, you cannot contribute to your Roth IRA.
Parents with Dependent Children
You cannot claim the Foreign Earned Income Exclusion and the Additional Child Tax Credit (up to $2,000). To be eligible for the Additional Child Tax Credit, the child must meet certain criteria, such as being under the age of 17 and being a US citizen or resident alien. We will help you evaluate which tax benefit is more advantageous based on your specific circumstances.
Filing Form 1116
To claim the Foreign Tax Credit, you’re required to file Form 1116 as part of your US tax return. The Foreign Tax Credit is calculated for each category of income separately. For example, if you’re claiming a credit for foreign taxes on your foreign wages and your foreign interest, you would have to file two separate Forms 1116. Taxes paid on the same category of income to multiple foreign countries are reported on one Form 1116. Similarly, if you are filing a joint tax return with your spouse and both are claiming a credit for foreign taxes, you would generally file only one Form 1116, combining your foreign income and foreign taxes on the same form.
Don’t hesitate to contact us to learn more about the Foreign Tax Credit. We specialize in the preparation of US tax returns for US taxpayers in Europe. We’ll provide personalized advice based on your individual circumstances and help you optimize your tax benefits.