You cannot claim both the Foreign Tax Credit (Form 1116) and the Foreign Earned Income Exclusion (Form 2555) on the same dollar of income. If you exclude the income from your tax return, you cannot also claim a credit on that same income.
U.S. taxpayers are taxed on their worldwide income- no matter where it was earned. However, if you have foreign sourced income, you have two options to avoid double taxation on that income: the Foreign Earned Income Exclusion and the Foreign Tax Credit.
Foreign Tax Credit - Form 1116
The Foreign Tax Credit is a dollar-for-dollar non-refundable tax credit for qualifying foreign income taxes paid. When using the Foreign Tax Credit, you prepare your return as normal including all of your income (no matter where it was earned). Once your tax has been calculated, the foreign tax credit is applied to the return reducing your US tax liability.
Not all foreign taxes qualify. To be deductible, the tax must meet four tests:
- The tax must be imposed on you.
- You must have paid or accrued the tax.
- The tax must be the legal and actual foreign tax liability.
- The tax must be an income tax (or a tax in lieu of an income tax).
Foreign Earned Income Exclusion - Form 2555
When using the Foreign Earned Income Exclusion, you are able to exclude up to $120,000 (2023) in foreign earned income from the return. The tax is calculated on your income minus the amount excluded. To qualify they must meet one of two tests:
Foreign Earned Income Exclusion vs. Foreign Tax Credit
In countries with low or no income tax, the Foreign Earned Income Exclusion would be more beneficial. In countries with higher tax rates, the Foreign Tax Credit may be more beneficial as it provides a dollar for dollar credit against your U.S. tax liability.
If you are not sure which is more beneficial, we recommend you prepare your return both ways and compare the results.
***Please note that you cannot claim both for the same dollar of income. If you exclude the income form your tax return, you cannot also claim a credit on that same income.
However, if you have a relatively high income in a country with a low tax rate, you may apply the Foreign Earned Income Exclusion to the first $120,000 and then use the Foreign Tax Credit to reduce the tax on the income above the $120,000 limit.