Tax Planning with the Foreign Earned Income Exclusion

The foreign earned income exclusion is terrific tax break for Americans who work and live abroad. With the foreign exclusion, Americans can earn up to $91,400 in foreign salaries completely tax-free. Above that dollar amount, people working abroad might be able to take advantage of the foreign housing exclusion or the foreign tax credit, which can help further mitigate any double taxation between the country where you are working and the United States.

But there is one thing to keep in mind when planning your taxes around the foreign earned income exclusion. Any taxable income in the U.S. will be taxed starting at the tax bracket that would apply had the foreign exclusion not been claimed. This particular point is confusing, and one reader emailed me to ask,

"Do I understand this correctly, if you make more than the exclusion you will pay the tax rate on the remainder of what the total would have been. But what about U.S. Military retirement source income and source income from moving back and working part of the year. Shouldn’t these two incomes be taxed at the normal rate. Not lumped in with the foreign exlusion. Everywhere I read it’s mainly foreign earned income that applies. Not U.S. source income."

The US tax brackets are graduated, and start at 10% on the first $8,350 of taxable income. (I'll use the 2009 tax rates for a single person in this example.) There are six tax brackets altogether, each covering a different ranges of taxable income.

Assuming you qualify for the maximum foreign exclusion, you would be in the 28% tax bracket for 2009. So any taxable income you have will be taxed starting at that rate. Now, persons working abroad are still eligible to take all the normal tax credits and deductions. For example, you'd be eligible to claim the standard deduction and personal exemption. For 2009, these amounts are $5,700 and $3,650, respectively. (And here's a list of more tax figures for 2009.) With just the standard deduction and personal exemption amounts, you have an additional $9,350 of income you can earn, tax-free.

So when planning for how much taxes you'll be likely to pay, figure out how much other income you will be receiving, as well as any deductions you can take (such as mortgage interest, property taxes, and charity). You'll then be in a position to know how much taxable income you have, and which tax rates will apply.

To give a quick example, let's say you only take the standard deduction and personal exemption, and your additional income is a retirement pension of $25,000 and some interest of $1,000. I'll further assume you will have a foreign wages of $91,400. Thus your total income (without the exclusion) is $117,400, minus your deductions of $9,350, and you have taxable income of $108,050, which puts you in the 28% tax bracket. Your actual taxable income (with the exclusion) is $16,650, and so your tax is likely to be 28% of that, or $4,662.

Basically, taking the foreign earned income exclusion has the effect of pushing your other income into a higher tax bracket that it normally would be in.