What is Foreign Earned Income Exclusion(FEIE): Limit, Eligibility, Calculation, Example

As a US citizen residing in a foreign country, you must have encountered the term “Foreign Earned Income Exclusion”. But do you know what is foreign-earned income exclusion?

The Foreign Earned Income Exclusion, or FEIE, was designed to prevent citizens of the United States from paying double taxes if they earn income from a foreign country. As an American citizen, if you earn income from overseas, the foreign country will tax your income. Additionally, the United States Internal Revenue System can again tax your entire income. Hence, FEIE ensures that you are not subjected to double taxation and receive a tax relaxation overall.

The Foreign Earned Income Exclusion taxation policy is also essential for citizens residing in the United States. The FEIE lets eligible individuals exclude a portion of their foreign income from the United States taxation policy. 

Let us learn more about the Foreign Earned Income Exclusion in detail and how you can take advantage of it as a US citizen residing in India or any foreign land.

Eligibility Criteria for FEIE

According to the rules laid down for the Foreign Earned Income Exclusions bucket, a taxpayer can only apply for FEIE if they pass either the Bona Fide Resident Test or the Physical Presence Test.

"Bona Fide Resident Test"

To apply successfully for FEIE tax relaxation, a U.S. citizen or a resident alien of a foreign country with which the U.S. has an income tax treaty must prove to be a Bone Fide Residence of a foreign country. A person is considered to be a Bona Fide Resident of any foreign country only if they have resided in a foreign land for an uninterrupted period of 1 year (entire calendar year). 

However, during this time, they can leave the foreign land for vacations or business trips and even return to the United States for such purposes. The main criteria is that you demonstrate that you are living abroad. Upon successfully passing the Bona Fide Resident test, an individual will fulfil the eligibility criteria to apply for FEIE.

"Physical Presence Test"

The Physical Presence Test needs to be cleared by an individual to apply for FEIE. To successfully pass the Physical Presence Test, an individual must reside in a foreign country for at least 330 days in a 12-month period. 

Note: The Bona Fide Residence test is often more difficult to clear as compared to the Physical Presence Test. 

Types of Income Eligible for Exclusion Under FEIE

The Foreign Earned Income Exclusion lets US citizens enjoy tax relaxation and prevents them from paying double taxes on their income earned from a foreign country. However, the FEIE is not applicable to all sources of income. 

The US IRS has laid down certain specific sources of income that are eligible to fall under the FEIE. These sources of income include:

• Salary
• Wages
• Bonuses
• Commissions
• Professional fees
• Income from Self-Employment/Businesses

Apart from the above-mentioned sources of income, any income generated in a foreign country by a US citizen will be taxable. Other sources of income often include passive income sources such as investments, which will be directly taxable and cannot be claimed under the Foreign Earned Income Exclusion.

Limits of FEIE

Undoubtedly, the Foreign Earned Income Exclusions come with a lot of advantages for US taxpayers, yet there are certain Foreign Earned Income Exclusion limits as well.

• The FEIE has a maximum exclusion cap ($1,26,500 for 2024). This cap changes every year, and any income above the listed exclusion amount is still subject to double taxation.
• The FEIE allows exclusions only to a certain type of income source, including salaries, wages, bonuses, commissions, or self-employment income. Any other source will be double-taxed without any tax relaxation.
• Claiming FEIE often affects an individual’s eligibility for other tax benefits, such as the Earned Income Tax Credit or the Child Tax Credit.

Thus, FEIE has its own downsides. However, this fact cannot be denied that its advantages outweigh its limitations.

Steps to Claim FEIE

In order to claim a foreign-earned Income Exemption, an individual must fill Form 2555. This form allows US citizens to claim foreign-earned Income Exemptions. Here are all the steps to claim FEIE as a US citizen earning income from a foreign country.

• Determine whether you are eligible to claim the Foreign Earned Income Exclusion based on the above-mentioned Bona fide residence test or Physical Presence Test.
• Fill the Form 2555 and attach all the necessary documents with it.
• Along with this, individuals might also need to fill out other forms, such as Form 1040, which is applicable to United States Individual Income Tax Return, or Form 1116 for Foreign Tax Credit.

Once you've completed it, submit Form 2555 to the Internal Revenue System of the United States. Form 2555 is valid for one entire tax year and must be filled out again to claim its benefits in the years ahead.

Advantages of FEIE for US Taxpayers

Apart from preventing foreign-resident US citizens from paying double taxation, the Foreign Earned Income Exclusion also offers many advantages for taxpayers. Let's understand them in detail.

• US taxpayers can also exclude a portion of their foreign-earned income with the help of FEIE. This reduces their overall tax liability depending on the foreign income they earn.
• Such efficient tax relaxation policies promote the international work culture among the citizens. People of the United States willingly look ahead to make international contributions and earn money from beyond borders.
• The FEIR promotes the international working culture in the United States and ultimately helps the country to take a competitive edge in the global market. 

Apart from providing tax relaxations, the FEIE brings with it a lot of advantages that help the country's overall progress.

Potential Pitfalls and Considerations

Contrary to many of the benefits that the FEIE brings, there are some common pitfalls and considerations that taxpayers must be aware of.

• The FEIE has a maximum exclusion cap ($1,26,500 for 2024) set by the US IRS for every tax year. Hence, foreign income exceeding the maximum exclusion cap is not subject to tax relaxation and is directly double-taxed.
• Even after reporting foreign income, individuals must file a US tax return reporting their overall income. 
• Claiming the advantages of FEIE may subject an individual to limited tax credits and deduction eligibility.
• Tax laws for FEIE may change over time. Hence, taxpayers must remain updated with the latest FEIE rules and regulations before filing their foreign income.

Example for Foreign Earned Income Exclusion

Let us understand with a Foreign Earned Income Exclusion example how an individual can attain tax relaxations. Mr. A is an American citizen who lives and works in India. Mr. A lived in India for 350 days in a tax year and went on a vacation back to the United States for 10 days. 

Mr. A earns a salary of $2,25,000 and pays $10,000 as taxes in India. However, his income is once again taxed by the United States Internal Revenue System, and a tax of $25,000 is due on him in the United States. 

However, Mr. A has been residing in a foreign country for more than 335 days, qualifying him for the Physical Presence Test. He also pays tax in a foreign country, so he can elect to take advantage of the U.S. Foreign Earned Income Exclusion policy.

The maximum exclusion for Foreign Earned Income Exclusion in 2024 is $1,26,500. Hence, Mr. A will be allowed to exclude $1,26,500 from his foreign income. However, the remaining $98,500 will be double taxed by the Indian government as well as the government of the United States.

However, Mr. A got a heavy tax relaxation in his income with the help of the Foreign Earned Income Exclusion policy which prevented a major portion of it from being double taxed.

Conclusion

To conclude, while the FEIE is a great way for US citizens to attain tax relaxations, taxpayers must remain updated with its constantly changing rules. 

Additionally, as a US taxpayer who earns foreign income, an individual must remember to take advantage of FEIE and prevent their hard-earned income from being double-taxed.