• Tax

What to claim, foreign tax credit (Form 1116) or foreign earned income exclusion (Form 2555)?

In order to provide relief from double taxation, both the Foreign Tax Credit and the Foreign Earned Income Exclusion are meant to do so; yet, they accomplish this goal in quite different ways.

Foreign Tax Credit: When you claim the Foreign Tax Credit, your tax return is prepared in the same manner as it would be if you had earned a portion (or all) of your income outside of the United States. The Foreign Tax Credit is used at the conclusion of the process, after your income tax has already been determined, and it is used to offset the taxes you have already paid to a foreign government, lowering your overall tax liability in the United States.

Foreign Earned Income Exclusion: The Foreign Earned Income Exclusion operates in a completely different way from the domestic earned income exclusion. It enables you to deduct from your reported income the portion of your income (up to $107,600 in 2020) that was generated in a foreign jurisdiction. After all, is said and done with the tax calculation, it is almost as if you never earned that income in the first place.

They are not only applied in a distinct way, but they also have significantly varied qualifying requirements.

There is a relatively low hurdle for the Foreign Tax Credit yet the bar for the Foreign Earned Income Exclusion is rather high.

For most taxpayers, the Foreign Earned Income Exclusion is the best option if their income is earned in a nation where there is little or no income tax. It will allow them to defer up to $107,600 (2020 figure) in U.S. taxation, whereas the Foreign Tax Credit would provide little or no benefit due to the fact that they are in a low- or no-income-tax country, respectively.

In addition, because the Foreign Tax Credit is used dollar for dollar against your U.S. tax burden, it is more advantageous when a taxpayer’s income is generated in a country with a high marginal tax rate. According to the latest available data (2020), the top tax rate in the United States is 37 percent. In the case of high-tax countries such as France (45 percent), Germany (45 percent), Israel (50 percent), or any other country where income is taxed at a high rate, the credit is more likely to be helpful.