Taxation on overseas income can be complex, but I will break it down in a way that makes sense. If you earn money outside the U.S., the IRS still expects you to report it. The rules differ based on whether you are a U.S. citizen, a resident alien, or a nonresident alien. I will explain how foreign income gets taxed, what exclusions apply, and how to avoid double taxation.
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Who Needs to Pay U.S. Taxes on Foreign Income?
The U.S. taxes its citizens and resident aliens on worldwide income. This means if you live abroad but hold a U.S. passport or green card, you must report income from all sources—whether earned in Texas or Tokyo. Nonresident aliens, however, only pay U.S. taxes on income tied to U.S. activities.
Key Terms to Know
- Foreign Earned Income: Wages, salaries, or self-employment income from outside the U.S.
- Foreign Unearned Income: Dividends, interest, capital gains, or rental income from foreign sources.
- Foreign Tax Credit (FTC): A dollar-for-dollar reduction in U.S. taxes paid on foreign-sourced income.
- Foreign Housing Exclusion: Additional deduction for housing expenses if working abroad.
How the Foreign Earned Income Exclusion (FEIE) Works
The FEIE lets qualifying taxpayers exclude up to \$120,000 (2023 limit) of foreign-earned income from U.S. taxes. To qualify, you must pass either:
- The Bona Fide Residence Test: You live abroad for an uninterrupted tax year.
- The Physical Presence Test: You spend at least 330 full days outside the U.S. in a 365-day period.
Example Calculation
Suppose I earn \$150,000 in Germany and meet the Physical Presence Test. Using the FEIE, I exclude \$120,000, leaving \$30,000 taxable in the U.S.
\text{Taxable Income} = \$150,000 - \$120,000 = \$30,000If my U.S. tax rate is 22\%, I owe:
\$30,000 \times 0.22 = \$6,600Without the FEIE, I would owe:
\$150,000 \times 0.22 = \$33,000The FEIE saves me \$26,400.
Avoiding Double Taxation: Foreign Tax Credit vs. FEIE
Some countries tax income at higher rates than the U.S. To prevent paying taxes twice, the IRS offers two solutions:
- Foreign Tax Credit (FTC): Directly reduces U.S. taxes by the amount paid to foreign governments.
- Foreign Earned Income Exclusion (FEIE): Excludes a portion of income from U.S. taxation.
Which One Should You Choose?
| Factor | FTC | FEIE |
|---|---|---|
| Best For | High-tax countries | Low-tax countries |
| Carryover | Excess credits carry forward | No carryover |
| Complexity | Requires Form 1116 | Simpler (Form 2555) |
If I pay 30\% tax in France and the U.S. rate is 22\%, the FTC makes more sense. I claim a credit for the extra 8\% paid abroad.
Reporting Foreign Bank Accounts: FBAR & FATCA
The U.S. requires disclosure of foreign financial accounts:
- FBAR (FinCEN Form 114): File if aggregate foreign accounts exceed \$10,000 at any point in the year.
- FATCA (Form 8938): Required for higher thresholds (e.g., \$50,000 single filers, \$100,000 married filing jointly).
Failure to report can lead to penalties up to \$10,000 per violation.
Self-Employment Tax on Foreign Income
Even if I exclude income via FEIE, self-employment tax (Social Security & Medicare) still applies. The rate is 15.3\% on net earnings up to
\$160,200 \text{Self-Employment Tax} = \text{Net Earnings} \times 0.153If I earn \$80,000 freelancing in Spain, I owe:
\$80,000 \times 0.153 = \$12,240State Taxes on Foreign Income
Some states tax overseas income even if excluded federally. California, for example, does not recognize the FEIE. If I’m a California resident earning \$200,000 in Japan, I must report the full amount to the state.
Common Pitfalls & How to Avoid Them
- Miscalculating FEIE Eligibility: Missing the 330-day requirement by even one day disqualifies you.
- Ignoring Foreign Pension Taxes: Some countries tax U.S. pensions—check tax treaties.
- Overlooking Foreign Housing Deductions: Expats can claim additional housing cost exclusions.
Final Thoughts
Overseas-income taxation is manageable if you understand the rules. The FEIE and FTC offer significant savings, but choosing the right one depends on your situation. Always consult a tax professional if unsure—especially if dealing with multiple countries.
