I often am asked this question by Expats and the truth is that there is no “one answer fits all” to this dilemma. However, a short explanation of how each works and the pros and cons of each can help the reader start to understand how to properly approach this issue.
Foreign Tax Credit:
The foreign tax credit is a basic credit that reduces ones US income tax liability based on the foreign income taxes that have been paid during the relevant tax period. If one has unused foreign tax credits from prior years, then they automatically get carried forward and can be utilized in future years where the taxpayer may not have paid sufficient foreign income tax credit to offset their US income tax owing. There are certain limitations and calculations that must be made that will sometimes create a situation where the taxpayer will not be able to utilize all of their foreign income taxes paid resulting in a US income tax liability even though they already paid significant foreign income taxes.
It must be noted that foreign social security taxes cannot be used for the foreign tax credit since only “income” taxes are allowable. This is a common error that is made and it must be noted that if the IRS audits the related personal tax return, they will disallow any foreign social security taxes, or any other taxes for that matter that are not “income” taxes.
In general, if the taxpayer lives and pays taxes in a country where the income taxes are generally higher than in the US, then the results of utilizing the foreign tax credit will usually be that the taxpayer owes zero income tax to the IRS. If the income is self-employed, then, depending on whether the US has entered into “totalization” agreement with the foreign country of residence, the taxpayer may have to pay US self-employment tax even though they have already paid the equivalent in their foreign country of residence. (Please see a list of countries that have entered into the “totalization agreement” on our website )
Foreign Earned Income Exclusion:
Firstly, as the name indicates, one can only take the foreign earned income exclusion on foreign EARNED income. As such, foreign passive income does not fall into this category. Another important point to realize about this exclusion is that one can either take the foreign earned income exclusion or take the foreign tax credit on the same income, but not both. In other words, if a certain amount of foreign earned income was excluded, and there is additional income leftover after the exclusion, then the foreign taxes paid on the income that was already excluded cannot be used to offset US income taxes on the remaining income.
The maximum foreign earned income exclusion amount for 2014 is $99,200. One does not have an option to take a partial exclusion. In other words, if one elects to take the exclusion, then they must exclude all of their foreign earned income up to the maximum amount of $99,200 in 2014 and cannot only take a partial exclusion. Why would anyone want to take a partial exclusion? There is one common instance that I have come across frequently that outlines a key deciding factor whether to use the foreign tax credit, or to take the foreign earned income exclusion:
If one has US children that they are claiming as dependents and are under 17 years of age, then one can be eligible for a $1000/child refund in additional child tax credits. However, one must have earned income to be eligible for these refundable credits and by taking the foreign earned income exclusion, they are no longer left with earned income to qualify for the refunds. As such, it would benefit many taxpayers to take a partial exclusion in order to qualify for the refundable child tax credits….however this is not an option.
One final point to consider regarding the foreign earned income exclusion is that once a taxpayer decides to take the exclusion, and then does not take it in a subsequent year, they are barred from taking it for the following 5 years.
In summary: Whether to utilize the foreign tax credit, or the foreign earned income exclusion is a complicated question and there is no “one answer fits all” to this question.
