For Americans working overseas, nearly ,000 a year of their earned income is tax free. This totally legal tax break is called the Foreign Earned Income Exclusion. Here is a look at this tax break, how it lowers tax burdens and why the government grants it.
What exactly is the Foreign Earned Income Exclusion? The IRS defines it like this:
"For this purpose, foreign earned income is income you receive for services you perform in a foreign country during a period your tax home is in a foreign country and during which you meet either the bona fide residence test or the physical presence test."
On other words, money earned for work performed by those residing overseas qualifies for the exclusion. There are two ways to qualify for this exclusion. One is to be a bona fide resident. Taxpayers can quality for this when they are bona fide residents overseas for an uninterrupted period over an entire tax year. The other is to pass the physical presence test. This is defined by the IRS as "if the taxpayer is physically present in a foreign country or countries 330 full days during a period of 12 consecutive months."
Earned income is defined as the salaries, wages, bonuses and professional fees that are paid for services performed while working overseas. Therefore, income such as capital gains, dividends, royalties etc. received while overseas are still legally taxable.
However, even though dividends and other unearned income are not excluded from taxes, the foreign earned income exclusion still lowers the rate at which these incomes are taxed. For example, if all the taxpayers earned income is excluded, their tax liability starts with their unearned income. If the total of the unearned income is less than their deductions, they still will not owe the IRS any taxes. If this income exceeds their standard deductions, the tax rate paid should still be lower since their deducted earned income does not push unearned income into a higher tax bracket.
However, working overseas is not a tax-free nirvana for most people. The main reason is that, apart from a few exceptions, most countries have income taxes too and usually tax foreign workers at the same rate they would tax their own citizens. These rates are sometimes higher than US rates.
Still, in sometimes gray areas of the law, foreign workers often slip under the tax radar. Also, different national tax jurisdictions usually do not work together. With income in different countries, it is unlikely any one tax jurisdiction will know the total earnings for any single taxpayer, especially if that taxpayer is a foreigner.
Why does the US government give this exemption? The major reason given is the competitiveness of US workers overseas. If overseas US workers have to pay US taxes while working overseas (many nations do not tax their nationals working overseas at all), US workers will be relatively more expensive to employ than those from countries that do not tax citizens working overseas.
Also, while Americans working overseas are not generally using taxpayer funded services, they are often pump money into the US economy when the send money back, shop on trips to the US and other occasions. Thus, there are economic advantages provided by Americans working overseas.
The overseas tax exclusion does have obvious tax advantages. However, these advantages are not as great as one might think on first glance, and there are economic reasons for giving this tax break.
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