Which tax break is right for you: foreign tax credit or foreign earned income exclusion?
As a US citizen or green card holder, you're required to file a US tax return – no matter where in the world you live or work. But filing doesn’t always mean you’ll owe taxes. Thanks to tax breaks like the foreign tax credit (FTC) and the foreign earned income exclusion (FEIE), many Americans abroad end up owing little to nothing in the US.
Foreign tax credit and foreign earned income exclusion help you avoid being taxed by both the country where you live and the US, but they do so in different ways. Choosing the right tax strategy or the right combination of both can make a significant difference in your tax outcome.
In this guide, we’ll break down the key differences between FTC and FEIE, explain how each works, and help you figure out which option fits your situation best.
This article is brought to you by Taxes for Expats (TFX) – a top-rated tax firm for US citizens and green card holders at home and overseas. If you’re looking for expert help with foreign tax credits and exclusions, we’re here for you. Book a free intro consultation, and we’ll review your case and walk you through your next steps.
FTC vs. FEIE
| Feature | Foreign tax credit (FTC) | Foreign earned income exclusion (FEIE) |
|---|---|---|
| What it does | Reduces your US tax by the amount of foreign income tax you paid | Excludes a portion of your foreign earned income from US taxation |
| Applies to | Income taxed by a foreign country | Earned income only (wages, salary, self-employment) |
| Limitations | Limited to US tax on foreign-source income | Limited to $126,500 (2024); $130,000 in 2025; adjusted annually |
| Passive income | Eligible (e.g., dividends, capital gains, rental income) | Not eligible |
| Residency requirement | Not required | Must meet physical presence or bona fide residence test |
| Carryover | Unused credits can be carried forward 10 years (or back one year) | No carryover allowed |
| Form | Form 1116 | Form 2555 |
| Self-employment tax | Does not reduce SE tax | Does not reduce SE tax |
| IRA eligibility | Income remains in AGI; IRA contributions allowed | Excluded income does not count toward IRA eligibility |
| Flexibility | Can switch year to year without restriction | If revoked, can’t re-elect for 5 years without IRS approval |
| Complexity | More complex (multiple income categories, sourcing rules) | Simpler for most filers |
What is the foreign tax credit (FTC)?
The foreign tax credit (FTC) is a key provision in the US tax code designed to protect American taxpayers from being taxed twice on the same income.
If you’re a US citizen or resident who pays foreign income taxes, the FTC allows you to reduce your US taxes by the amount of income tax you've already paid to a foreign country.
The FTC can be used for foreign wages and salaries, self-employment income earned abroad, interest, dividends, and capital gains (if taxed by a foreign country), and rental income or royalties sourced from a foreign country.
To claim the FTC, you must file Form 1116 with your tax return. In limited cases where foreign tax is below a certain threshold and paid on passive income, you may qualify for an exception and skip the form.
How to qualify for the FTC
- The tax must be imposed on you by a foreign country or US possession.
- The tax must be a legal and actual foreign income tax (not voluntary).
- The tax must be based on income, not services, property, or other unrelated items.
- You must have paid or accrued the tax during the year you’re claiming the credit.
The income must also be foreign-source. If the income is US-source, you can’t claim FTC, even if it was taxed by a foreign country. The IRS has specific sourcing rules depending on the type of income.
Carryover provision
If you can’t use the full credit in a given year, the IRS lets you carry back unused credits one year and carry them forward for up to 10 years or carry back one year.
However, the income must be in the same category as where the FTC carryover is stored. For instance, you can't use excess FTC for foreign tax paid on a rental property to offset tax due wage income.
Missed the foreign tax credit on a past return? You may still be able to claim it!
If you didn’t claim the foreign tax credit when you filed your taxes, you can correct it by submitting an amended return (Form 1040-X). In most cases, you have up to three years from the original filing date to make changes. By doing this, you could get back hundreds or thousands of dollars (depending on your situation) from the IRS.
Before filing ensure your amended return is accurate, well-documented, and includes all supporting information.
What is the Foreign Earned Income Exclusion (FEIE)?
The foreign earned income exclusion (FEIE) allows US citizens and green card holders living abroad to exclude a portion of their foreign earned income from US taxation.
For tax year 2024, the maximum exclusion is $126,500 per qualifying taxpayer; $130,000 in 2025. If you're married and both spouses qualify, each can claim the exclusion – doubling the benefit to $253,000 in 2024; $260,000 in 2025.
You can claim the exclusion by filing Form 2555 with your US tax return.
How to qualify for the FEIE
To use the FEIE, you must meet three basic requirements:
- You must have foreign earned income (wages, salary, or self-employment income).
- Your tax home must be in a foreign country.
- You must pass either the physical presence test or the bona fide residence test.
Physical presence test vs. bona fide residence test
- To meet the physical presence test, you must be physically present in one or more foreign countries for at least 330 full days in any 12-month period. This test is based strictly on time spent abroad and does not require any permanent ties to the country.
- The bona fide residence test is more flexible in terms of travel, but requires stronger ties to a foreign country. You must be a tax resident in a foreign country for an entire tax year and demonstrate that you’ve established a long-term residence there. Factors like employment, family location, and local tax status all contribute.
If you meet any of those two tests, and you’re a tax resident of a foreign country, you can generally claim FEIE on your foreign earned income.
Passive income such as dividends, capital gains, rental income, and interest does not qualify for the FEIE.
Excluded income under the FEIE doesn’t count for US retirement contribution purposes.
Can I use both FTC and FEIE?
Yes, you can use both the foreign tax credit and the foreign earned income exclusion, but not on the same income or the same portion of income.
If the income is different, you can claim both tax benefits. For example, you can use FTC for PFIC taxes (Form 8621 or through the Form 1116), and FEIE for your regular income.
If your foreign earned income exceeds the FEIE limit, you may be able to apply the FTC to the remaining taxable portion. Here’s how it can work:
- You exclude $126,500 of earned income using the FEIE.
- You have an additional $40,000 in earned income that is still subject to US tax.
- You paid foreign income taxes on the full $166,500.
- You can apply the FTC to the $40,000 of income not covered by the FEIE.
This combination might suit high-income earners whose foreign wages exceed the FEIE cap and expats with both earned and passive income from foreign sources.
Using both the FEIE and FTC can require careful allocation of income and taxes. Missteps can trigger IRS scrutiny.
How to choose between FTC vs. FEIE
Choosing between the FTC and FEIE depends on several factors: where you live, how much you earn, what kind of income you have, and how long you’re abroad.
- Country of residence: If you live in a high-tax country where foreign tax rates are equal to or higher than US tax rates, the FTC is often more advantageous. If you live in a low-tax or no-tax country, the FEIE might offer better relief.
- Total foreign income: If your earned income is below the FEIE limit ($126,500 in 2024), and you meet one of the residency tests, FEIE can eliminate your US tax on that income. If you earn significantly more, combining FEIE with the FTC could reduce tax on the excess.
- Type of income: The FEIE only covers earned income. If you receive dividends, capital gains, or rental income, you’ll need to rely on the FTC.
- Length of stay abroad: The FEIE requires that you pass either the physical presence test or the bona fide residence test. If your time abroad is short or inconsistent, the FTC offers more flexibility.
If you paid foreign taxes on your investment income, you may be able to use the FTC to offset your US tax liability and reduce the risk of double taxation. Sourcing of income depends on how much foreign tax was paid. If less than 10%, it’s a US-sourced income and cannot be offset by foreign taxes paid.
You’re allowed to change your tax approach from one year to the next – for example, claiming the FEIE one year and switching to the FTC the next. However, once you elect the foreign earned income exclusion and then choose to revoke it, you can’t claim it again for the next five tax years without IRS approval. This is outlined in IRS Publication 54. The foreign tax credit has no such restriction.
Neither FEIE nor FTC reduces self-employment tax, which applies at 15.3% on net income.
Not sure which tax break fits you best? Get expert advice
Choosing between the foreign tax credit and the foreign earned income exclusion isn’t always straightforward. It depends on many factors, including your income level, the type of income you earn, and your tax residency.
The year you move abroad or return to the US can be especially complex. It often includes income earned both inside and outside the States, which may affect your eligibility for each provision.
If you have multiple sources of earned or passive income across countries, choosing the right strategy could significantly reduce your US tax bill.
At Taxes for Expats, we’ll walk you through your options and recommend the best one to lower your tax liability – wherever you live.
