The United States is one of only two countries in the world that taxes the worldwide income of citizens who live abroad. No matter how long you live outside the US, you must pay tax and file a mountain of forms to Uncle Sam every year.
The only way to escape this burden is by giving up US citizenship entirely in a process called expatriation.
Expatriation – giving up US citizenship and passport – is the only way for a US citizen or permanent resident to legally and permanently end their obligation to pay tax on their worldwide income.
After expatriation, a former US citizen or permanent resident pays tax only on their US-source income – and some types of domestic income are tax-free.
The Foreign Earned Income Exclusion (FEIE)
Giving up your passport just to avoid taxes is a radical step for many. One most Americans living abroad are not ready to take. But at the same time, they don’t like the idea of paying Uncle Sam a big pile of tax dollars every year when they don’t even live there.
Thankfully, the tax man offers ways to reduce your tax bill back home if you live overseas. The best one in many cases is called the Foreign Earned Income Exclusion or FEIE for short.
Here are the key points of this little-known tax break:
The Foreign Earned Income Exclusion in a nutshell…
The program allows you to exclude up to $126,500 per year of foreign earned income from federal income tax. The exemption doubles to $253,000 for married couples, both of whom are living and working abroad. These are the limits for 2024; the thresholds are adjusted each year for inflation.
What about non-taxable fringe benefits?
Non-taxable fringe benefits paid to you in the United States are also non-taxable overseas. Your employer can pay for your health insurance, for example. They can also contribute to a US retirement plan with no extra tax liability.
You can also claim housing expenses against US taxes
You can also exclude or deduct some or possibly all your housing expenses from your gross income earned abroad. This “foreign housing cost amount” applies to housing expenses paid by your employer. If you are self-employed, you can take a deduction only for housing expenses.
If your foreign earned income is more than the maximum allowable FEIE, you may also be able to claim the foreign housing exclusion (FHE). This exclusion allows you to exclude the market value of some housing expenses (rent, repairs, insurance, and utilities other than telephone) if you have a foreign employer.
In most cases, the maximum FHE is $17,710, adjusted annually, but the exclusion or deduction is greater in certain high-cost locations.
If you’re married and both you and your spouse work overseas, only one spouse can exclude housing expenses, unless you maintain separate households. Still, in combination with the FEIE, that gives you and your spouse over $270,000 of earned income each year you can jointly exclude from US taxation.
Do you still have to pay Social Security and Medicare Taxes?
In most cases, you do.
The FEIE won’t reduce your liability to pay Social Security and Medicare taxes on your foreign earned income unless you’re working for a non-US employer. But you still might be liable for foreign social insurance taxes.
If you work for a US employer, it will withhold these taxes the same way it would if you lived and worked in the United States; 6.2% of your wages for Social Security tax and 1.45% for Medicare taxes—a total of 7.65%. Your employer will pay another 7.65% of your wages directly to the IRS.
The total tax liability for both employer and employee comes to 15.3%. There’s no Social Security tax on earnings that exceed $168,600 in 2024 (adjusted annually), but Medicare tax applies to all earned income.
If you have a US employer, you can’t avoid these taxes unless a “totalization agreement” is in effect between the United States and the country in which you are living and working. Here’s a list of countries with totalization agreements in effect.
In these countries, instead of paying US Social Security and Medicare tax, you pay into their social insurance system. The agreements also eliminate the possibility of double taxation; i.e., that you would be required to pay social insurance taxes to both countries on the same earnings.
How do you qualify for the Foreign Earned Income Exclusion?
At its simplest, you must prove you have a new “tax home” outside the US. This means a jurisdiction that can tax your income based on residence or other ties. That said, you don’t have to live in a country that actually imposes an income tax.
You must also file a US tax return annually, along with IRS Form 2555.
You must also qualify under one of two tests to be eligible for the FEIE:
- Physical presence test.You qualify under this test if you’re physically present in a foreign country for at least 330 full days during any period of 12 consecutive months.
- Bona fide residence test.If you have established legal residence in another country for an uninterrupted period of at least one calendar year (January 1– December 31), you qualify under this test. You must also be either a US citizen or a resident alien who is a citizen of a country that has an income tax treaty with the US. If this last condition doesn’t apply, a resident alien must qualify for the FEIE under the physical presence test.
What options do you have if you live overseas but don’t qualify for the FEIE?
If you don’t qualify for the FEIE, you can take either a tax credit or a deduction for income taxes imposed on you by a foreign country. If the taxes are higher in a foreign country than what you would pay on the same income in the US, the foreign tax credit will be more valuable than the FEIE.
How’s that? Because under this program, you can’t “double dip”, meaning you can’t claim the FEIE and a tax credit / deduction off foreign taxes.
Case Studies
Case Study 1: John’s Move to Canada
John is a software engineer from the US. He has moved to Canada for an overseas management position with his American tech company. His annual salary is US $220,000, with his employer paying another $10,000 in housing expenses per year.
Taxes in Canada
In Canada, residents are taxed on their worldwide income using a progressive tax system. For simplicity, let’s assume John is living in Ontario, where the combined federal and provincial tax rates could lead to a maximum marginal rate of around 50%. For an income of US $220,000, John could expect to pay a combined provincial-federal tax of roughly 36% of his income in taxes, amounting to approximately US $83,000. In Canadian currency, those payments would total around $112,000.
US Tax Liability – FEIE Scenario:
With the FEIE, John can exclude up to US $126,500 of his income from US taxes, plus a portion of his housing expenses. After applying the exclusions, all but US $93,500 of John’s income would be excluded. This income would be subject to US taxation. Based on the 2024 brackets for US federal tax, John would owe more than US $30,000 in additional US tax.
US Tax Liability – Tax Credit/Deduction Scenario:
In this scenario, John could claim foreign tax credits for the taxes he paid in Canada. Based on the US federal tax brackets, John’s tax liability on his Canadian income comes to around US $51,000. Given his Canadian tax bill of US $83,000, John can offset his entire US tax liability, given the high Canadian taxes paid, reducing his US tax obligation to zero.
Summary:
Comparing the two scenarios, the tax credit approach is more favorable for John., The high Canadian taxes he pays completely offsets his US tax liability.
Case Study 2: Emily and Alex’s Retirement in Costa Rica
Emily and Alex, a married couple from the US, have chosen Costa Rica for their retirement. They no longer work and their annual income of $125,000 comes from a combination of Social Security benefits, private pensions, and returns on their investments.
Tax Regime in Costa Rica:
Costa Rica utilizes a territorial tax system, meaning that residents are taxed only on income earned within the country. Since Emily and Alex’s income comes from the US, they would not be subject to Costa Rican income tax on their income.
US Tax Liability – FEIE Scenario:
The FEIE applies only to earned income from work or self-employment. Since Emily and Alex’s income consists of Social Security, pensions, and investment income, they would not qualify for the FEIE on this income. Their US tax liability would be determined by standard IRS rules for such income types, considering applicable deductions and tax rates for married couples filing jointly.
US Tax Liability – Tax Credit/Deduction Scenario:
Given that their income isn’t subject to tax in Costa Rica due to the territorial tax system, Emily and Alex wouldn’t have foreign taxes to credit against their US tax liability. Their US tax would be calculated based on standard tax rates and rules applicable to their income types, without the benefits of foreign tax credits for the income in question.
Summary:
In the case of Emily and Alex, the FEIE is not applicable due to the nature of their income. Their tax situation in Costa Rica is favorable due to the territorial tax system, under which their foreign-sourced retirement income is not taxed. But they remain responsible for their US tax obligations on their retirement income, calculated according to standard IRS rules for such income.
Case Study 3: Ethan’s Graphic Design Business in Nevis
Ethan is a very successful freelance graphic designer who has decided to make Nevis his new home and business base. Through his US-registered LLC, Ethan earns an annual income of $330,000. He claims $15,000 in annual housing-related expenses through his company.
Tax Regime in Nevis:
Nevis has no direct personal income taxes. So the personal income derived from Ethan’s US LLC is not subjected to local income taxation in Nevis.
US Tax Liability – FEIE Scenario:
Ethan can benefit from the Foreign Earned Income Exclusion (FEIE) by excluding up to the FEIE limit (using the 2024 limit of $126,500 for illustration) from his US taxable income. Ethan is also eligible to claim a housing exclusion for his $15,000 housing expenses in Nevis. This effectively reduces his taxable income from his graphic design business to $188,500 (i.e., $330,000 – $126,500 – $15,000).
US Tax Liability – Tax Credit/Deduction Scenario:
Since Ethan’s income does not incur taxes in Nevis, there are no foreign tax credits available to offset his US tax obligations. Therefore, his US tax liability would be calculated on the total income from his LLC, less standard business deductions and any applicable business expenses that might reduce his taxable self-employment income. Even with the FEIE, Ethan will still pay more than $45,000 in federal income tax. But without it, he’d pay more than $85,000.
Summary:
Utilizing the FEIE and housing exclusion, Ethan can significantly decrease his taxable income in the US from his freelance graphic design activities. However, it’s important to note that the FEIE does not apply to self-employment taxes, meaning Ethan would still be responsible for these on his net business earnings.
A WARNING: Only use the FEIE if you meet the requirements
Sometimes we get contacted by people who live overseas and want to claim the FEIE but don’t actually qualify. We don’t recommend it.
The IRS carefully reviews tax returns with an FEIE submission (Form 2555) to ensure compliance. Trying to cheat the system can lead to significant penalties.
Conclusion
The Foreign Earned Income Exclusion can be a valuable tool for Americans living and working abroad. It allows them to significantly reduce their US tax liability.
But it’s important to understand the requirements and limitations of the exclusion.
Need Help?
Over the past 40+ years, we’ve helped thousands of clients build a better wealth protection plan. A good number of them are American citizens who live and work overseas, and have to deal with draconian, never-ending obligations to Uncle Sam.
Over that time, we’ve become experts at helping overseas Americans deal with issues that come with these obligations.
If you’re thinking about heading overseas… or you’re already living overseas and need some help, consider working with us.
It starts with a free, no-obligation consultation with one of our Associates. You can do that here.
