Tax Know-How: Foreign Income Exclusion   ARTICLE

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Foreign Earned Income Tax Exclusion for Living and Earning Income Abroad
by Shane Flait ©2012


One boon for living and working abroad is a sizeable exclusion from U.S. taxable income. But only ‘earned’ income counts and if it’s very high, you’ll face higher taxation on excess income. Here’s how it works.


Only ‘earned’ income has an exclusion

U.S. tax law requires U.S. citizens to report their worldwide income no matter where they live. But if you live abroad and meet residence requirements, you may exclude a portion of your foreign earned income – up to $92,900 in 2011, indexed for inflation in future years. Foreign ‘earned’ income is income earned while overseas.  It doesn’t include federal tax-designated ‘unearned’ income such as investment income like interest, dividends and capital gains, as well as U.S. Social Security benefits, pension income, or any income earned as a U.S. government employee.


If you happen to be a sole proprietor or in a partnership where both capital investment and your personal services together produce your foreign income, then excludable earnings is the smaller of your personal services or 30% of your net profits.


Residence and personal presence test

To be eligible to exclude any overseas income, you have to have a tax home in a foreign country that meets either the Internal Revenue Service's bona fide residence or physical presence requirement. Your tax home is your regular place of business or employment. The IRS wants to be sure that you don’t simply travel there periodically to earn money. You need a genuine home in the country for a full tax year or spend at least 330 days abroad earning your income.


Now the wrinkle:

The Tax Increase Prevention and Reconciliation Act (TIPRA) changed how any foreign income in excess of the exclusion ($92,900 – for 2011) is taxed. Instead of applying the normal U.S. tax rate - starting at the lowest bracket - to income not excluded, the excess is taxed in the tax bracket it would have been before the exclusion is allowed. This means you’ll lose the tax-reducing value of the lower brackets for those higher earnings.

As an example, suppose you make $120,000 overseas. If you exclude the $92,900, then the unexcluded $27,100 (= $100,000 less $92,900) isn’t taxed beginning at the 10% tax rate and moving up. This excess is now taxed at the rates associated with no foreign income exclusion. So watch out. 

Living in a tax haven

Realize, though, that you must pay whatever income is due to the foreign country you’re residing in. However, there are countries – referred to as tax havens – that only tax income earned within their borders.  That’s to your advantage.




Shane Flait is a writer and educator. Get more info at