Contrary to popular belief, American expats do not have to be stuck with a high US tax burden, when also paying high taxes in their residence country. The truth is, with the Foreign Tax Credit expats can often reduce or even eliminate their US tax.
This guide explains what the Foreign Tax Credit is and how US citizens abroad can benefit.
What is the Foreign Tax Credit?
The Foreign Tax Credit (FTC) is a dollar-for-dollar credit for taxes paid to a foreign country on foreign-sourced income. Expats who pay eligible foreign taxes can use this credit regardless of whether there is a tax treaty or not.
Even better, the FTC can be used for several different types of foreign taxes (list in the next section).
Taxpayers claim the credit on Form 1116, which they file together with their tax return.
By the way, some expats can combine the Foreign Tax Credit and the Foreign Earned Income Exclusion for larger savings.
Can I claim a credit for foreign taxes?
Many expats can claim the Foreign Tax Credit on their US tax return to offset taxes they paid in a foreign country. To qualify, basic requirements must be met:
- Have income that has been taxed by a foreign government
- The tax must have been “imposed” and was not optional
- The tax has been paid
- The income was not already excluded (Read more about a popular exclusion for expats here.)
Furthermore, Americans abroad should keep in mind that only some types of foreign taxes qualify.
What taxes qualify for the Foreign Tax Credit?
Americans can receive the Foreign Tax Credit for foreign taxes on the following:
The good news is that income from self-employment and employment both qualify.
On the other hand, certain taxes do not qualify.
For example, foreign provincial, state, or regional taxes do not qualify for the FTC. Likewise, you cannot receive Foreign Tax Credits for wealth taxes based on net worth.
A more specific example of a non-qualifying tax would be the church tax in Germany. The German solidarity surcharge (“Soli”) however does qualify.
Should expats use the Foreign Tax Credit or the Foreign Earned Income Exclusion?
Often, US taxpayers living abroad are not sure if the Foreign Earned Income Exclusion or the Foreign Tax Credit is better for them. They both have advantages but choosing the wrong one can be costly.
There are many factors to consider before choosing the FTC over the FEIE. Key considerations include:
- Tax rate in the country of residence
- Ability to contribute to retirement plans
- Claiming the child tax credit.
Let’s look at each of those.
Living in a high tax jurisdiction
Often, US Americans living in a high tax country pay higher taxes there than they would have paid in the US. Those expats typically benefit from using the FTC instead of the FEIE.
Alternately, if an expat has a foreign tax rate that is lower than their US tax rate, they should consider the Foreign Earned Income Exclusion.
The tax rate of your residence country however is not the only factor to consider.
Making a Roth or traditional IRA contribution
To be able to contribute to an IRA, the taxpayer must have un-excluded income. If expats use the FEIE to exclude all their income from income tax, they do not have any un-excluded income left for IRA contributions. Since IRAs have tax advantages, you cannot use income excluded from taxation to make a contribution.
So you might think that you should use the Foreign Tax Credit instead. However, you might still be able to contribute to an IRA when using the FEIE.
Claiming the FEIE does not preclude expats from making an IRA contribution as long as they have un-excluded income that they can use for the contribution.
For example, if an expat has foreign income that exceeds the FEIE limit, then he has non-excluded income and can contribute. Similarly, income that is not foreign-sourced, for example from working during a business trip in the US, cannot be excluded and therefore can be used for IRA contributions.
Expats that want to make retirement contributions should discuss their options with an experienced expat tax accountant.
Claiming the Child Tax Credit
Eligible expats can use the Child Tax Credit and the Foreign Tax Credit together. This allows them to reduce their US tax burden even further.
In some cases, the Child Tax Credit can bring the tax bill to zero. Some even receive a refund from the IRS. In 2019, up to $1,400 of the Child Tax Credit is refundable.
Of course, there are some qualifications for the Child Tax Credit, such as having eligible US children and income under the bracket.
Foreign Tax Credit carryover to future years
The Foreign Tax Credit not only reduces current year income tax. It can also reduce a future tax burden.
When you pay higher taxes abroad than you would have in the United States, the FTC can bring your current year US tax liability down to zero. And you can claim any unused tax credit in future years.
This is called a carryover (more on this below).
Expats can use these carryover credits later when they maybe move to a low tax jurisdiction (such as Hong Kong or the UAE). Thereby, they reduce their long-term tax obligations.
On the other hand, if the foreign tax rate is lower than the US tax rate, the Foreign Earned Income Exclusion might make more sense.
Unused tax credit carryovers and carrybacks
As mentioned, carryovers and carrybacks can reduce the US expat tax burden beyond the current tax year.
It works like this:
When an expat pays more in income taxes to a foreign government than they would to the US government, the IRS lets them keep the extra foreign tax credits. Unused foreign tax credits do not result in a US tax refund.
Instead, expats can use the extra foreign tax credits later or apply them to the previous tax year.
US taxpayers can carry forward foreign tax credits for up to 10 years.
Or you might apply foreign tax credits to the previous tax year. This is referred to as a carryback. Carrybacks can only be applied to the prior tax year but not to earlier years.
If you have a Foreign Tax Credit carryover from previous years, remember to tell your accountant– especially if you are switching accountants. At Online Taxman, we review the last three years of tax returns for new clients to make sure nothing gets missed.
How to use the FTC
Let’s explain this with an example:
Jane is an American expat living in London. The United Kingdom is a high-tax jurisdiction. In the UK, Jane pays more income taxes than she would if she lived in the United States.
Jane’s accountant helps her claim the FTC on Form 1116. For each dollar of income tax she pays to the UK, she receives a dollar foreign tax credit.
The foreign tax credit is applied to her US tax burden. Since Jane paid more in the UK than she would have in the US, her US tax is zero.
Jane is planning to move in the next few years to a low-tax country. There, she can carry over the unused foreign tax credits to reduce her US taxes while still paying less in foreign taxes.
Should you choose the Foreign Tax Credit?
The Foreign Tax Credit has many advantages. That does not mean it’s the right choice for everybody.
In fact, in some cases, expats could lose money with the Foreign Tax Credit. Sometimes, the Foreign Earned Income Exclusion is a better choice.
A careful analysis of each expat’s unique tax situation and long-term plan is crucial.
Our team of expert expat accountants is happy to walk through these life and tax decisions with you. Set up a one-on-one consultation with one of our accountants below.