Foreign Earned Income Exclusion vs Foreign Tax Credit (FEIE vs FTC): Difference & Which is Better?

Many individuals earning income from a foreign country are confused about whether they should use the Foreign Earned Income Exclusion or the Foreign Tax Credit. While both have advantages and disadvantages, choosing the most appropriate option for yourself becomes an important task.

In this article, we will examine the major concepts of foreign earned income exclusion and foreign tax credit, determine the key differences between them, and help you decide which option is most appropriate.

What is Foreign Earned Income Exclusion

If an American citizen earns money from a foreign nation, they are exempt from paying double taxes with the help of Foreign Earned Income Exclusion or FEIE. If you are an American citizen and you make money abroad, you will be taxed on your income by the foreign country. Furthermore, the US Internal Revenue Service may tax your entire income again. Therefore, FEIE ensures you don't pay taxes twice and get a general tax relaxation.

Through the FEIE, qualified persons can exclude a portion of their overseas income from US taxation.

What is a Foreign Tax Credit

A Foreign Tax Credit, or FTC, is a credit that can be claimed by US citizens who pay taxes to a foreign country. The FTC helps US taxpayers relax their tax amount and prevents their money from being taxed twice.

The Foreign Tax Credit is also of great importance for US citizens since it helps them easily claim credit for their foreign-earned income. As a result, the FTC reduces US taxpayers' overall tax liability by providing tax relaxation.

FEIE Qualifying Income Sources

Although FEIE lets you gain tax relaxation on your foreign-earned income, there are only a few specified income sources for which the FEIE can be claimed. These are:

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

Apart from these income sources, no other source of income generated in a foreign country can be claimed under FEIE. Any other source of income will be directly taxable by both the foreign country and the citizen’s own country.

When and Who Can Claim the FEIE

In order to successfully claim the FEIE on your foreign-earned income, an individual must qualify either for the Bona Fide Resident of a foreign country or should fulfil the Physical Presence Test. Let us understand them in detail.

• Bona Fide Resident: To be eligible for the FEIE tax relief, a person must provide proof that they are bona fide residents of a foreign nation. 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 one year (the 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.

• Fulfilling the “Physical Presence Test”: To apply for FEIE, an individual needs to pass the Physical Presence Test. To successfully pass the 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. 

FTC Qualifying Income Sources

 Foreign Tax Credit can be claimed on most of the income sources. These include:

• Salaries/Foreign Employment Income
• Foreign Business Income
• Dividends
• Interests
• Capital Gains

These types of income sources qualify successfully to be claimed under the FTC. 

When and Who Can Claim the FTC

Anyone who is a US citizen, has a foreign income and falls under the United States taxation slab is eligible for a Foreign Tax Credit (FTC). According to the US IRS, the eligibility criteria for FTC are as follows:

• A Foreign Tax Credit can be claimed only by a resident of the United States and on the tax they pay in a foreign country.
• An individual cannot claim FTC on the amount paid as interest, fee, or penalty.
• An individual can claim a Foreign Tax Credit for the same year in which they have paid tax in the foreign country.

To claim the Foreign Tax Credit for your foreign income, you must complete Form 1116. The Form specifically asks individuals to report their foreign income and thereafter claim a credit for it.

Hence, a person must check their eligibility to apply for the Foreign Tax Credit. Thereafter, they must fill out Form 1116 with all the necessary documents attached so as to successfully claim their credit on their foreign income.

Key Differences Between Foreign Earned Income Exclusion (FEIE) & Foreign Tax Credit (FTC)

Here are the key differences between the Foreign Earned Income Exclusions and the Foreign Tax Credit.