What's the difference between the foreign earned income exclusion (FEIE) and the Foreign tax credit (FTC)? Which one is more advantageous?
They both sound very similar, but are very different.
The foreign income exclusion "excludes" foreign income from being counted towards a taxpayer's income. In fact, the income will even be excluded from their final "AGI" or adjusted gross income, which is a famous metric of a person's total income. For the 2022 tax year this amount will be increased to $112,000. So any foreign income below this amount can be excluded from paying any US income tax.
Now for the foreign tax credit: A taxpayer has the right to claim a credit for tax paid to a foreign country, for a given source of income.
When the tax rate of the country of residence is more than the US tax rate (such as Europe and Israel in most instances), utilization of the foreign tax credit will result in $0 US tax left to pay.
Normally, it is more worthwhile to utilize the foreign tax credit if possible. There are several reasons:
1) Carryback and carryforward periods available for the credit, which may be valuable.
2) Income-based credits, such as the Child Tax Credit, cause refundable credits only if the taxpayer has unexcluded income. Excluded income using the foreign income exclusion is ineligible as basis for the credit.
3) In order to contribute to a Roth IRA, one must have unexcluded income.
However, in certain instances, such as if the country of residence has a low tax rate, the foreign income exclusion may be the best option.
Note that self-employment tax cannot be excluded by the FEIE or FTC, as it is a type of tax which cannot be excluded.
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