# Pitfalls of the FEIE



## FFMralph

The Foreign Earned Income Exclusion (FEIE), Form 2555, is probably the instrument that is most often used by expats. It does however, have it's pitfalls. 
Here are a few that come to mind:

*Losing the FEIE*
The IRS chooses whether or not to accept your qualification under the Bona Fide Residence Test. If the IRS feels, for any reason that you do not qualify they can revoke your status.

If you do not take the FEIE for any tax year it is considered revoked. If you wish to reclaim the exclusion within the next 5 tax years again, you must apply for IRS approval.

As a bona fide resident of a foreign country, the IRS does not state how often or how long your length of stay in the U.S. can be. But if you exclude under the Physical Presence Test you are limited to a maximum of 35 days within a 12 month period. 
To many trips or lengthy stays may disqualify your bona fide residence status. 


*No provisions for retirees*
If you are a retiree, your pensions cannot be excluded. If no provisions are made in a tax treaty, your only option is the FTC to eliminate or offset double taxation.

If you take the exclusion up until retiring, you may lose up to 10 years of valuable tax credit carry overs. _*Plan your retirement!*_


*Discrimination of highly qualified*
If your earnings exceed the FEIE limit your only option is the FTC or combination of the FEIE & FTC to eliminate or offset double taxation

Homeowners usually do not qualify for the Foreign Housing Deduction

Does anything else come to mind?


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## BBCWatcher

The FEIE's Physical Presence Test is very cut and dried. The Bona Fide Residence Test is simply a second, backup test that catches and qualifies more people. That's not a bad thing!

You've overstated revocation of the FEIE. It is quite possible, even common, to hop onboard the FEIE years after you're first eligible. (Read the fine print, but there's not much with that scenario.) You may be thinking of hopping off (while still eligible) then hopping back on. That second scenario requires obtaining a tax ruling from the IRS.

I'm not sure what you mean by the "plan your retirement" admonition with respect to choosing whether or not to take the FEIE (versus FTCs on that income). Passive income is in a separate category from earned income when considering the accumulation of excess FTCs. It doesn't do you much if any good to accumulate excess FTCs against earned income in order to offset future income taxes on passive income -- they're separate buckets. Moreover, everybody has their personal exemption and standard (or itemized) deduction(s) to shield some income from taxation. In tax year 2014 the personal exemption and standard deduction (combined), assuming Married Filing Separately, is worth $10,150 all by itself. That's not counting anything else you might qualify for, and that's assuming no partial phase-out scenario (applicable to rather high incomes and above). Note that qualified Roth IRA and Roth 401(k) withdrawals (as notable examples) are U.S. tax free, so, if also foreign tax favorable, that'd be a smart way to plan for retirement -- and in that narrow sense there might be some reason to decide for or against the FEIE.

I'm not sure what "Discrimination of Highly Qualified" means. The FEIE (and FHE) are simply limited in how much earned income they shield from taxation. No discrimination there. Everybody with earned income who resides overseas can take the FEIE, even somebody with a salary of $6 million per annum. Is there discrimination when Apple stores limit purchases of new iPhones to two per customer? I'd say no, that's not discrimination.

None of these are "pitfalls." The FEIE/FHE has a few limits to be aware of, that's all. An actual "pitfall" might be the inability of an individual to make qualified IRA contributions if they shield all (or at least nearly all) earned income using the FEIE/FHE.


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## FFMralph

Discrimination in that a limit exists. Why can't someone earning 100k eliminate 100% the same as someone earning 50k? He is forced to take the FTC and that means he may be double taxed if he lives in a low tax country.

Planning for retirement means if you live in a high taxed country, you should collect the tax credits up to 10 yrs prior to going into retirement. If you don't, and you move to a lower taxed country, you will probably be double taxed on your foreign pensions (not 401(k)) and or earnings. Also you need to be aware that after retirement you cannot take the FEIE. You need to be certain that all provisions have been made to eliminate the possibility of double tax.


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## BBCWatcher

FFMralph said:


> Discrimination in that a limit exists. Why can't someone earning 100k eliminate 100% the same as someone earning 50k?


He can. The Foreign Earned Income Exclusion is $99,200 for tax year 2014. Add in his (worst case) personal exemption and standard deduction, and that $100,000 income earner residing overseas owes zero U.S. income tax.

A person pulling down a salary of $2 million gets the same $99,200 maximum FEIE. One rule, uniformly applied to everyone. That's not discrimination in any common understanding of the word. Each and every customer who walks in the door can buy as many as 2 iPhones. Every diner who walks into the 2 hour buffet gets 2 hours to eat. It's a simple limit, not discrimination.

Are U.S. residents discriminated against because they cannot take the FEIE/FHE? 



> He is forced to take the FTC and that means he may be double taxed if he lives in a low tax country.


No, he's never double taxed. If he lives in a low tax jurisdiction he pays a total tax rate equal to (or sometimes less than) the U.S. resident rate. If he lives in a high tax jurisdiction he pays a total tax rate equal to the foreign tax rate. "Double taxed" means he'd pay tax rate X to country X and tax rate Y to country Y on the same income, and X+Y is greater than both X an Y. _That's_ double taxed.

He can be, sometimes, taxed in both jurisdictions, which is what I think you're trying to say. Is a New York State resident "double taxed"? No.



> Planning for retirement means if you live in a high taxed country, you should collect the tax credits up to 10 yrs prior to going into retirement. If you don't, and you move to a lower taxed country, you will probably be double taxed on your pensions and or earnings. Also you need to be aware that after retirement you cannot take the FEIE. You need to be certain that all provisions have been made to eliminate the possibility of double tax.


No, you're misunderstanding how the FEIE and FTC (don't) interact here. The FEIE (and FHE) only apply to earned income. Retirement income is passive income, and passive income (pre or post retirement) is never excluded via the FEIE/FHE. The Foreign Tax Credit is really plural -- Foreign Tax Credits. Part of its plurality is that you can (if you live in a high tax jurisdiction) opt to accumulate excess Foreign Tax Credits on earned income and, separately, you may also be able to accumulate excess FTCs on passive income. But the two don't mix. You can't "bank" and later "spend" excess FTCs on earned income across your passive income. Earned FTCs go to earned, and passive FTCs go to passive -- they don't mix.

That's why tax filers end up filing a pair of Form 1116s (FTCs): one for earned income, and one for passive. Or often only one (for passive) while they take the FEIE/FHE, assuming they don't have rather high earned income (some distance past $99,200 in tax year 2014). (There's a third FTC income category as well, but it's not so common.)

So go ahead and take the FEIE/FHE. Or not. It's a separate decision. What you do there will have no impact on the extent to which you can accumulate excess (passive) FTCs to then offset income tax on future passive income when you're retired (or even when you're not).


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## FFMralph

Thanks for setting me straight on the FTC. I was placing pensions in the "General" category. You're right, they belong to "Passive". Under that aspect, the FEIE has no effect on carryovers for passive tax credit. 

And you're right about double taxed too. I mean being taxed twice. But you're right, it doesn't exceed 100% of the U.S. amount.

I guess we should be happy that at least a portion (if not all) of our earnings can be excluded. Better would be taxation based on residence.


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## Bevdeforges

I'll let you guys in the upper income brackets debate the "pitfalls" of the FEIE. Just a couple of comments on what you have presented here:

Have you heard about (m)any cases where someone has been denied the FEIE based on bona fide residence? It will become more critical this year, with the ACA question being added to the 1040 form. Being able to claim you have "Minimum Essential Coverage" as an overseas resident is based on your meeting either the bona fide resident test or the physical presence test. But I can't say I've ever heard of anyone being denied the FEIE based on "too many trips back to the US" under the bona fide resident criteria. (Admittedly I haven't really researched the issue to any extent.)

And I'll just repeat what I have said several times here in the past. It's not simply a matter of whether you live in a "high tax" or a "low tax" jurisdiction as to whether or not you should be going FTC rather than FEIE. Different tax systems have different thresholds, allowances, deductions and rates of taxation for various sources of income. You really have to run the numbers in your particular case to decide which option is more beneficial for you. 

Just for the record, although I live in an acknowledged "high tax jurisdiction" (i.e. France), we paid no income tax for a number of recent years. Only income tax is eligible for the FTC, not any of a number of various taxes that might be part of the local income tax declarations. And for those years where we have had income tax to pay, the attribution of those taxes to the various sources of income would not have been beneficial to my US tax situation at all. Hence my comments to the effect that if both methods will "only" get you to 0 tax due (i.e. with no carry over), the FEIE is probably the quicker and easier route to take. (Also less subject to question in a review or audit situation.)
Cheers,
Bev


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## FFMralph

*Conclusion:* We as expats are privileged in being able to exclude all or part of our foreign earned income. 

We should not owe taxes if the remaining income (regardless of the source) after excluding, minus exemptions and deductions is less than the starting tax brackets.
Taxes may be due if the remaining income is higher than the starting tax brackets. This is where each of the FTCs (General & Passive) come into play.


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## BBCWatcher

FFMralph said:


> We as expats are privileged in being able to exclude all or part of our foreign earned income.


About 91% of U.S. persons residing overseas are fully shielded from U.S. income tax thanks to the FEIE and FHE (and personal exemption, deductions, etc.) if a certain professor's estimates are correct. (They seem to be at least highly plausible.) An additional 3% are fully shielded thanks to the FTC according to that same professor's estimates.

Some U.S. residents would call that discrimination. 

In all seriousness, language matters. Start tossing around words like "discrimination" and somebody else could then pause, think, and... "Hey, wait a minute! I'm the one discriminated against here!" It's a variation of "Be careful what you wish for." 

For the record I'd like to see something that allows you to spend up to, say, $10K of your FEIE limit to exclude taxable passive income (all sources, U.S. and non-U.S.), even if it means cutting back the FHE and reducing the FEIE limit a bit. Call this combined thing the "Overseas Resident Income and Housing Exclusions" (ORIHE) let's say. Make it relatively simple such that you have to take the $10K portion (or less if you have less passive income) first, then you take your foreign (only) earned income up to the remainder of the overall limit, plus the housing exclusion if applicable. (Or you can still take the FTC only path.) That adjustment to pull in some passive income would be kinder and gentler to retirees of relatively modest means living overseas, in particular. I think there's a potential winning political argument there. I also think that tweak would be relatively cheap requiring only small offsets elsewhere.

That'd mean $20,150 or more of a hypothetical retiree's worldwide taxable income (all passive) would be U.S. tax exempt when factoring a MFS personal exemption and standard deduction -- a big improvement.



> We should not owe taxes if the remaining income (regardless of the source) after excluding, minus exemptions and deductions is less than the starting tax brackets.


And tax credits. There are several, e.g. the Child Tax Credit and Additional Child Tax Credit. The U.S. starts at negative income tax rates through operation of the Earned Income Tax Credit in particular.



> Taxes may be due if the remaining income is higher than the starting tax brackets. This is where each of the FTCs (General & Passive) come into play.


You can say it a bit stronger with some more detail. U.S. income tax will be due on the remaining foreign source income higher than the starting non-negative tax rate bracket if the foreign income tax rate on that same income is lower, if there are no previous excess Foreign Tax Credits available to offset tax on that category of income, if the income is not U.S. tax exempt (not a qualified Roth IRA withdrawal for example, often not Social Security benefits as another example), and if a tax treaty does not shield the income from U.S. income tax. According to that same professor about 6% of U.S. persons residing overseas -- roughly 400,000 individuals -- thread this particular needle and owe some nonzero amount of U.S. income tax on their foreign source income.

To elaborate a bit, there are some very interesting forms of income that are U.S. income tax exempt. For example, although the U.S. has an estate tax (on estates substantially north of $5 million in total value), there is generally zero tax owed if you inherit a foreign estate of any size from someone other than one of the very few covered expatriates (a former U.S. person who was subject to the exit tax upon renunciation of U.S. citizenship).


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## jbr439

Concerning double taxation: there is one place where it does seem to exist. FTCs cannot be applied against the Net Investment Income Tax (NIIT). So, it's a case of double taxation.


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## BBCWatcher

A potential one, yes indeed. Then again, the world is chock full of double, triple, and quadruple taxation. Live in France, pay French income tax, then pay French VAT as you consume the remainder of your already French taxed income, for example. That example is all French.

We're all double taxed on restaurant bills in Singapore.  The hamburger costs X, then a 10% service charge is added, then 7% GST is added to both the X price and the service charge.


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## theOAP

I'll not point to one single post, but there seems to be an assumption created in this thread regarding in which basket on a Form 1116 pension distributions (regular monthly, quarterly, or yearly) are placed. (Passive, General, or Resourced by Treaty.) These are distributions made after one retires and are the benefits paid regularly for years, and not a lump sum payment.

I can't offer a reward, but I would be eternally grateful if anyone can point to exact wording regards which basket the regular paid benefits of a foreign pension are placed in on a 1116. I'll accept wording from the Code, any IRS publication, or any IRS information available anywhere.

TIP: within the Code there is a definition of passive verses general income, but it is not specifically related to distributions from a foreign pension.


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## FFMralph

A pension payment is, I believe, considered an "annuity".

According to Form 1116 annuities are the category "passive".



> Passive income generally includes dividends, interest, royalties, rents, *annuities*, excess of gains over losses from the sale of property that produces such income or of non-income-producing investment property, and excess of gains over losses from foreign currency or commodities transactions.


Instructions for Form 1116 (2013)


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## BBCWatcher

Wow, great question!

If there's no information suggesting otherwise then it'd drop into general category since that's what the IRS says about income that you cannot find a place to put. General category is the "safety net," as it were. And that'd probably work well if so.

Actually I was really thinking about private investments supporting retirement. The gains, dividends, and interest on those investments would be passive category nearly always.

I took several minutes to see if I could find something, but I didn't find anything obvious. The FTC categories are allegedly defined in IRS Regulation 1.940-4, but that's some very dense reading with a lot of cross references and definitions to unpack.

One thing to keep in mind is that "pension" covers a lot of ground. In particular, I could imagine a scenario where a portion of the "pension" is effectively deferred wages (general category) and another portion is capital gains/accrued interest/accrued dividends (passive category). The FTC instructions at least hint at such possible distinctions and income splits.

The categorization alone can have a big impact, so it's not a minor point you raise. I don't agree that all pensions are annuities. Some probably are -- the pure "defined benefit" pensions -- but others probably aren't.


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## FFMralph

If it gets dropped into the "General" category, then collecting tax carryovers prior to retiring just became an issue.

Pensions and Annuities are both defined in Pub 575 Pensions and Annuities.
Different but similar enough to be placed in one publication.


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## BBCWatcher

It doesn't really bear on the question of whether or not to take the FEIE/FHE versus the FTC-only path. If you can accumulate excess FTCs on that earned income then you might as well take the FTC-only path. Otherwise, no. That decision is pretty straightforward.

It does, however, bear on how "spendable" those excess FTCs are. For example, if the "pension" is really deferred wage income from the U.S. point of view (thus FTC general category), but it's foreign tax-favored, then those excess FTCs become very spendable, plus you could probably keep piling on to your U.S. IRAs (since you have earned income), if my understanding is correct. That'd all be nice if so.

Isn't this fun?


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## theOAP

FFMralph said:


> Pensions and Annuities are both defined in Pub 575 Pensions and Annuities.


Remember, we're talking about *foreign* pensions which are not *qualified* US pensions.


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## BBCWatcher

Agreed. They might be PFICs, in particular (particularly if "defined contribution"), and the IRS talks about how to categorize those.

Then there are foreign government pensions and social security retirement benefits (called "pensions" in many countries), and those are likely different, too.

The IRS didn't use the P word in discussing FTC income categories, and all these variations is probably why.


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## Bevdeforges

The other big thing to consider is the tax treaty between the US and your country of residence - if the pension is a government pension. Some of the tax treaties define quite clearly which government has the right to tax a government pension.
Cheers,
Bev


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## salrasheid

I want to talk about my case which i experience the worst case of using FEIE . I want to correct me the experts of tax system.
I am a father of 3 childrens working abroad with a salary of $40000 . If iam not using the FEIE i would get child tax credit with about $3000 and the tax liability for my bracket is much smaller than this amount . If i am using FEIE i would't get the child tax credit and i just cancel the small tax liability due without benefiting from the child tax given money.
I am not sure if there is something wrong in my understanding or this is aloophole in tax system. I need someone expert to make comment for what i mentioned.


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## FFMralph

You can exclude 100% of your earnings leaving your total income at $0.00.
Further exemptions or credits won't do you any good because you are not entitled to a refund
if living/working abroad.


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## salrasheid

I can optionaly select not to use FEIE and then i am eligible to get the child tax credit according to my qualified children and the salary earning income. Any one has some point view?


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## BBCWatcher

That's correct. You can take the Additional Child Tax Credit if you have taxable earned income. The FEIE wipes out your $40,000 of earned income, denying you that refundable tax credit.

The income tax rates in Jordan range from 14% to 25%. They appear to be high enough that you'd be better off skipping the FEIE and taking only the FTC. But you'll need to check that and make sure you're comfortable with that decision.

Note that your dependents must be living with you and U.S. citizens or U.S. nationals (since you're overseas). Be careful to make sure they qualify.


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## salrasheid

My children are us citizen but I sent them to us later , some study in university and the other in high school . I read that if they out of my home overseas because of study is eligible to consider they live with your home and i support them for their living in us .I am not sure for my understanding for this ,please any one can help ?
Regarding what you are talking about the pitfall using FEIE is that you did't take the child tax credit and the additional credit . Unlike the earned income credit , you can take it without the condition to live with you in us.


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## BBCWatcher

Your interpretation may be correct -- they don't have to be with you in your arms every minute of the year certainly -- but read the IRS's child tax credit instructions carefully.

These child credits are sometimes available to overseas residents, yes, but they are not usually compatible with the FEIE/FHE -- you are correct.


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