# Foreign Earned Income Tax Exclusion



## bfw471

Greetings. I have a tax question concerning the FEIE that I cannot quite clear up by reading the IRS Pubs. This concerns an American citizen living and working in Afghanistan (not sure whether expats is just an American term  ) This will be my first year using the FEIE, and I wanted to know whether one can choose to pay taxes on a portion of earned income that would usually be covered by the FEIE? The IRS Pubs simply states that one can exclude up to $97,600, but it does not say whether one can choose to exclude less if one earns less. I do not make more than the max income allowed by FEIE, so all of my income would be potentially tax free; however, I am having issues with funding my ROTH IRA without earned income. Could I choose to pay taxes on a portion of my earned income (just enough to make a max ROTH contribution) even though I do not cross the max allowable exclusion? If I file the IRS Form 2555, must I include all of my earned income below the max allowable exclusion?

In addition, I am having issues finding a suitable retirement investment vehicle considering the definition of "earned income." Does anyone have any advice on tax sheltered accounts available to Expats or individuals deriving their income from overseas? I understand that it is going to be difficult finding a tax shelter. The IRS is going to get a cut one way or another. I'm considering just taking advantage of the FEIE and opening a simple brokerage account until I move back to the states. I believe having the saved funds from the FEIE upfront (not paying taxes) is much more advantageous than having access to certain tax sheltered accounts (and paying taxes to have "earned income") with regards to the time value of money. Any advice on saving for retirement while an Expat would be much appreciated. As many do in the states, I feel like I'm being heavily penalized for trying to save.


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## Bevdeforges

You don't have to take the FEIE on your foreign earned income. If you're paying taxes to another government (like Afghanistan), you can always opt for the Foreign Tax Credit instead of the FEIE. That leaves all your earned income available for putting into a Roth or other IRA.

However, if you are working as a civilian contractor in Afghanistan, your pay may not be considered eligible for the FEIE anyhow. Stumbled onto this little memo in my research: www.irs.gov/pub/irs-utl/am2009003.pdf One of the statements relates to whether a civilian contractor in a "Combat Zone" can be considered tax resident in the country in which they are working. So it may be a moot point anyhow. If all your earned income is taxable by the US, you're free to fund your Roth under the regular rules.

As an expat, since you are supposed to be "tax resident" in the country where you are living and working, you are pretty much assumed to fall under that country's retirement system. The real kicker is that Uncle Sam doesn't make any allowances for foreign retirement investment schemes, even if they are nearly identical to the US IRA, 401K or other such schemes. 
Cheers,
Bev


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## bfw471

First, let me thank you for the reply. Filing for the FEIE is my best option. It will increase my income by 20-30%. I do not qualify for the Foreign Tax Credit as I do not pay local taxes. I am a civilian contractor in Afghanistan that has created a "tax home" through the 330 day physical presence test. 
My main issue is with the verbiage used in the IRS pubs. It states that one can exclude up to $97,600 for 2013. The "up to" phrase seems ambiguous to me. For example, if I made $85,000 (total income for 1 year period of FEIE) that can be excluded via Form 2555, may I simply choose to only exclude $80,000 (thus paying taxes on $5,000 of earned income and making an allowance for a $5,000 Roth IRA contribution)? Contrarily, if I file Form 2555, am I obligated by the IRS to exclude the full $85,000 as outlined above? This $85,000 from above is below the max limit, meaning if fully excluded, I would technically have $0 earned income because the IRS does not allow income excluded using the FEIE to be contributed to a Roth.

I apologize if my posts are confusing. 

I may have found my answer on the Americansabroad.org website (would not allow me to post link) foreign-earned-income-and-roth-ira-contributions-revised by Barron Harper
The tenth paragraph reads:
So if you are married filing jointly and your foreign earnings in 2011 were $97,000, your allowable funding for a Roth IRA would be seemingly be $4,100 ($97,000 92,900). But in actuality the amount allowable is only 3,900 ($110,000 97,000 x 30%); bearing in mind in this example that MAGI would be $97,000 if no other items of income. * But you cannot reduce FEIE below your foreign earnings to qualify your income for a fuller Roth contribution. *Perversely you cannot opt to take FEIE in favor of taking 100% of the foreign tax credit. On other hand, if you have no retirement plan at work, the MAGI thresholds are irrelevant to reducing your Roth contribution. 

I found this while penning my reply, but it doesn't hurt to have second opinions from individuals that have dealt with these issues personally. I am having difficulty adjusting my retirement savings plan with the FEIE. It looks like I'm limited to a taxable brokerage account. Things get difficult when you get your cake and would like to eat it too.


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## BBCWatcher

Like Bev I am somewhat skeptical you can take the FEIE.

If you still insist on taking the FEIE -- a big audit flag in your circumstances it would seem -- then you've still got a couple possible options for tax advantaged savings:

1. If your spouse has sufficient earned income not subject to the FEIE then he/she may be able to make Roth IRA contributions for you;

2. You can contribute to 529 college savings plans;

3. Municipal bonds and qualified municipal bond funds are U.S. federal tax exempt, though these are probably not such a good idea in your situation for other reasons.


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## Bevdeforges

I've run across similar comments in other tax sources, but was unable to dig one of them up when responding to your initial query. But as far as I know, the FEIE is an all-or-nothing option. You exclude the total of your earned income from overseas or you exclude nothing.

And, I saw that thing about whether or not a civilian contractor can establish a "tax home" in a Combat Zone, and I confess I didn't understand it at all. You plays the game and you takes your chances. I believe the idea was that civilian contractors are supposed to be treated more or less like US military personnel, which means they aren't entitled to the FEIE - but if I'm correct in that interpretation, the IRS will no doubt be in touch. (And if I'm wrong, they won't be.)

Frankly, those of us living overseas who are US citizens have very reduced options concerning retirement savings. If we take advantage of the local retirement savings plans, they aren't recognized by the US, and any tax advantages granted by our local governments are negated by the US taxation rules. Such is life, I guess.
Cheers,
Bev


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## bfw471

I understand your skepticism; however, using the FEIE is very common in my current professional field. After reading your link concerning issues arising with civilian contractors, I noticed that it states civilians do not qualify for exclusion under Section IPC 112 (which is for military and it provides a Q code on W-2/I used to be military). Contractors generally meet the standards of physical presence test (PPT) under the IPC 119 section of that document. 
I did have some further questions regarding the FEIE. This question may be somewhat vague, but what does this phrase mean specifically: "Once you choose to exclude your foreign earned income or housing amount, that choice remains in effect for that year and all later years unless you revoke it." What does it mean by remaining in effect for all later years until revoked? Does that just mean once I file for FEIE once, I must do so in any later years I meet the physical presence or residence test? 
Also, may one have two 12 month qualification periods using the PPT in the same tax year. For example, say I start work overseas in February 1st, 2012 through January 31st, 2013 on a one year contract. I meet the PPT, so I am eligible for the FEIE; a partial for most of 2012 and January of 2013. I go back to the states after completing the contract for 3 months. On May 1st, 2013 I begin a new one year contract overseas until April 30th, 2014. For the 2013 tax year, can I claim the January partial year from the first contract and start and claim a new 12 month partial for the second contract from May to December 2014? In this situation, you would essentially be claiming two qualification periods in the same year.


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## BBCWatcher

bfw471 said:


> I understand your skepticism; however, using the FEIE is very common in my current professional field.


Yes, and it's also been very common, according to reports, for the IRS to audit your profession in these circumstances. And the IRS has been collecting back taxes with interest and penalties.

I think you're operating under the mistaken impression that passing the physical presence test is enough to qualify for the FEIE. It is not. The IRS explains. In particular, the IRS has rules for determining whether your tax home is inside or outside the U.S. Remember that Afghanistan has an income tax. If Afghanistan doesn't think your tax home is in Afghanistan, it probably isn't.

Anyway, don't try to do this on your own. Consult a professional.



> This question may be somewhat vague, but what does this phrase mean specifically: "Once you choose to exclude your foreign earned income or housing amount, that choice remains in effect for that year and all later years unless you revoke it." What does it mean by remaining in effect for all later years until revoked? Does that just mean once I file for FEIE once, I must do so in any later years I meet the physical presence or residence test?


As mentioned those tests are triggered when you meet the base conditions for a possible foreign tax home. That provision means if you qualify for the FEIE you cannot in later tax years switch to using the Foreign Tax Credit to shield that income. You must take the FEIE for that qualifying income instead of the FTC. You can't bounce back and forth, cherrypicking the most favorable tax treatment.



> Also, may one have two 12 month qualification periods using the PPT in the same tax year. For example, say I start work overseas in February 1st, 2012 through January 31st, 2013 on a one year contract. I meet the PPT, so I am eligible for the FEIE;


No, probably not, but let's continue....



> a partial for most of 2012 and January of 2013. I go back to the states after completing the contract for 3 months. On May 1st, 2013 I begin a new one year contract overseas until April 30th, 2014. For the 2013 tax year, can I claim the January partial year from the first contract and start and claim a new 12 month partial for the second contract from May to December 2014? In this situation, you would essentially be claiming two qualification periods in the same year.


If you qualify for the FEIE in both periods in your example you would have a 2012 tax year with the FEIE plus an additional pro-rated month (January, 2013) for the 2013 tax year. If you then file in May, 2014 -- allowed if you qualify for the extended deadline of June 15, or if you apply for an extension -- you would meet the 12 month retrospective requirement and could classify the time starting from May, 2013, as FEIE time.

But the pattern you're describing makes it even more unlikely that you qualify for the FEIE at all since the IRS would be unlikely to agree that Afghanistan is your tax home, and thus you never get to the physical presence test.


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## BBCWatcher

Here's the IRS's 2009 memo on this subject.

The more reading I do, the more I see the tax professionals advising U.S. contractors in Afghanistan not to try taking the FEIE unless they're very unusual (such as having a spouse/family living indefinitely in Thailand that they always go back to on leave and no U.S. ties). One tax professional estimates the chance of audit at 5 to 10 percent, which is quite high. The IRS has hired contractors (ironically) to review such cases, so it's not a question of limited IRS resources. Penalties have been typically 20% according to reports, plus original taxes and interest. There is no political cover on this: U.S. soldiers in Afghanistan have to pay income taxes (though they get a more limited combat zone exclusion if they qualify).

Read the IRS's guidance on the concept of "tax home." My guess is you won't clear that hurdle, so you never get to either of the second order tests (bona fide residence test or physical presence test). Though there are benefits if you don't qualify: you can save in tax-advantaged accounts such as the Roth IRA, and you'll continue to have U.S. Social Security credits and coverage (if that was in doubt).

Also, if you have to pay legitimate taxes to the government of Afghanistan, you can take the Foreign Tax Credit. Tax professionals have been advising contractors to make sure their employers calculate foreign taxes and report them on W-2s, for example, and there's been a lot of recent controversy about that. The good news is that you shouldn't have to pay twice: you can take the FTC if there are legitimate foreign income taxes you're getting charged whether you're getting a W-2 or not. Key word for Afghanistan is legitimate. Not bribes, for example (which are illegal anyway according to the FCPA).

Anyway, that's my advice for what it's worth. See if you can get past the "tax home" requirement. Probably not is my guess.


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## Bevdeforges

BBCWatcher said:


> As mentioned those tests are triggered when you meet the base conditions for a possible foreign tax home. That provision means if you qualify for the FEIE you cannot in later tax years switch to using the Foreign Tax Credit to shield that income. You must take the FEIE for that qualifying income instead of the FTC. You can't bounce back and forth, cherrypicking the most favorable tax treatment.


Just a bit of clarification here. I think what is intended is that once you have elected to take the FEIE, it is assumed you will continue to take it for subsequent years until and unless you don't. But, if you choose in a later year to go with the foreign tax credit or just to voluntarily drop the FEIE when you are qualified for it, that will be deemed a "renunciation" and you can't go back to the FEIE for a certain period of time (I think it's 5 years) unless you request permission to do so from the IRS.

There's no obligation to continue to take the FEIE - but once you stop, you can't just go back to it unless you have good reason. (Say, for example, you return back to the US for a couple of years and then take another foreign assignment in a different country.)
Cheers,
Bev


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## BBCWatcher

Yes, agreed. I think that's a better explanation. Thanks Bev.


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## bfw471

Thanks for all of the information. You've really helped steer me in the right direction with my research. 
Though I'm a military contractor, I am a full-time intermittent employee on W-2 status. Each statement of work is for a one year period that is renewable; however, being a full-time employee, I believe that I have established my "tax home" based on being outside OCONUS for an indefinite period of time. It would seem to me that being a full-time employee helps create the "tax home" (indefinite stay regardless of work statements) as opposed to being independently or self-employed.


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## BBCWatcher

Then where is your tax home if not the United States? I'm asking before the IRS's auditor does.


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