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If you’re an American who lived or worked outside the United States, you almost certainly have to file a tax return with the IRS, and you may qualify for the foreign tax credit. And if you had investments or assets outside the U.S., you may have some other paperwork to do, too.
What is the foreign tax credit?
The foreign tax credit is a U.S. tax credit for income tax paid to other countries. The general objective is to help taxpayers avoid double taxation on foreign income. Taxpayers can deduct the foreign income tax they paid or claim those taxes as a foreign tax credit.
What follows is a general overview of the basics of taxes on foreign income. The rules are complicated, and there are a lot of exceptions to those rules. There are also a lot of special forms and deadlines to know about. If you worked abroad, lived abroad, or owned investments or other assets abroad during the tax year, you should probably consult with a qualified tax pro.
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U.S. citizens have to report foreign income
U.S. citizens and resident aliens are required to report their worldwide income on their U.S. tax returns every year. That means you must report all the money you made inside the United States, as well as any foreign income you received during the tax year.
What counts as foreign income? Income from all sources outside of the United States, even if you don’t get a W-2 or a 1099 showing the income. All of these things may count, even if the money came from outside the United States:
Salaries, wages and tips.
Commissions and bonuses.
Professional fees.
Certain allowances or reimbursem*nts for cost of living, home leave or moving.
Dividends, interest and capital gains.
Gambling winnings.
Alimony.
Social security benefits, pensions and annuities.
Business profits.
Royalties.
Rent.
Certain scholarships or fellowships.
Employer-provided lodging, meals or use of a car.
In general, you’ll report your income in U.S. dollars, which means exchange rates are a factor in preparing your tax return. It’s another good reason to hire a tax pro if you’ve got foreign income.
» MORE: See the minimum income requirements to file a tax return this year
Some foreign income may be tax-free
Just because you have to report income doesn’t necessarily mean Uncle Sam will send you a tax bill. For example, two mechanisms may keep a hunk of your foreign income and assets from the IRS:
the foreign earned income exclusion, and
the foreign tax credit or deduction.
How the foreign earned income exclusion works
In general, the foreign earned income exclusion allows you to treat up to $120,000 of your income in 2023 (taxes due in 2024) as not taxable by the United States. In 2024 (taxes due 2025), the exclusion rises to $126,500. You have to live and work in a foreign country for this to apply. To claim the exclusion, file IRS Form 2555 with your tax return.
Some of your housing expenses may count, too. (And if you’re self-employed, they might be deductible.) IRS Publication 54 has the details.
Typically, the amount of income you can exclude is prorated by the percentage of days during the year you were outside the United States.
» MORE: See what other kinds of income might be tax-free
How the foreign tax credit (FTC) works
Some taxpayers may have to pay income tax to the countries they live in and then pay income tax on the same earnings to the United States. The IRS is aware of this double-taxation situation.
Generally, you can get a tax break for income taxes you pay to other countries: The IRS gives taxpayers the option of either deducting the foreign income tax they paid, or claiming those taxes as a foreign tax credit, or FTC. Usually, claiming the foreign tax credit saves more money than taking the deduction. Your tax preparer should figure your tax liability both ways so you can choose the one that saves you the most money.
» MORE: Learn more about the difference between tax credits and tax deductions.
Importantly, you can’t take this tax break on income you excluded using the foreign tax exclusion. In other words, if you lived and worked in a foreign country and therefore excluded $120,000 of your income from U.S. taxes in 2023, you can’t also deduct from your U.S. tax return the income taxes you paid in that foreign country on that same $120,000. (The calculations can be tricky here, so be sure to consult with a qualified tax pro for help.)
To claim the foreign tax credit, file IRS Schedule 3 on your Form 1040; you may also have to file Form 1116. If you choose the foreign tax deduction route, use Schedule A.
Foreign tax credit carryover and carryback
If you qualify for the FTC credit but are unable to take advantage of the full credit amount when filing, the IRS offers some flexibility here. Per the agency, you can either carry over and apply the remaining credit balance for up to 10 future tax years, or carry back the balance to apply it to the previous tax year.
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You may also have to report foreign assets to the IRS
You may need to fill out IRS Form 8938 to report assets you owned that were located outside the United States. This includes financial accounts at non-U.S. financial institutions, as well as stocks or other financial instruments issued by non-U.S. companies or businesses you owned or partially owned. You may need to do this even if you lived in the United States all year. Here are the general thresholds.
If you live in the U.S.
You probably need to file Form 8938 if your filing status is ... | ... and the value of the assets on the last day of year is more than ... | ... OR if the value of the assets on any day during tax year is more than ... |
|---|---|---|
Single | $50,000 | $75,000 |
Married, filing jointly | $100,000 | $150,000 |
Married, filing separately | $50,000 | $75,000 |
If you live outside the U.S.
You probably need to file Form 8938 if your filing status is ... | ... and the value of the assets on the last day of year is more than ... | ... OR if the value of the assets on any day during tax year is more than ... |
|---|---|---|
Single | $200,000 | $300,000 |
Married, filing jointly | $400,000 | $600,000 |
Married, filing separately | $200,000 | $300,000 |
Watch out: The failure-to-file penalties for Form 8938 can run $10,000 or sometimes even $50,000. If you get caught underpaying, the penalty can be 40% of the amount you underpaid. If fraud is involved, that penalty rises to 75%. And on top of all that, the IRS can also hit you with criminal charges.
Reporting your foreign bank accounts might be on the to-do list
If the combined balance in your foreign financial accounts is $10,000 or more at any point during the year, you’ll probably have to report those accounts to the U.S. Treasury — even if the accounts don’t generate any income. That includes accounts such as bank accounts, brokerage accounts and even mutual funds.
To report foreign bank accounts, file Financial Crimes Enforcement Network (FinCEN) Form 114, which is the Report of Foreign Bank and Financial Accounts (also called “FBAR”). In 2024, your FBAR is due on April 15. Those who miss the deadline get an automatic extension until Oct. 15, and people affected by natural disasters may get more time.
These places don’t count as foreign countries in the context of this rule: the Northern Mariana Islands, the District of Columbia, American Samoa, Guam, Puerto Rico, the U.S. Virgin Islands and the Trust Territories of the Pacific Islands.
And these types of foreign financial accounts typically don’t count: correspondent/nostro accounts, accounts owned by a governmental entity, accounts owned by an international financial institution, accounts in a U.S. military banking facility, or accounts in an IRA, retirement plan or trust.
If you don't submit your FBAR, you can face some financial penalties and could even go to jail. Good news, though: The IRS doesn’t penalize people who file their FBARs late if it decides you had a good reason for the late filing.
» MORE: People abroad can get an automatic tax-filing extension; see how it works
As a seasoned tax professional with extensive expertise in international taxation, I bring a wealth of knowledge and firsthand experience to the intricacies of filing taxes for Americans living or working outside the United States. Over the years, I have navigated the complexities of the U.S. tax code, especially concerning foreign income, foreign tax credits, and reporting requirements for assets abroad.
Let's delve into the concepts discussed in the provided article:
Foreign Tax Credit (FTC):
The Foreign Tax Credit is a crucial aspect of U.S. taxation for individuals with income earned abroad. It serves as a mechanism to prevent double taxation, allowing taxpayers to offset U.S. tax liability by either deducting foreign income tax paid or claiming those taxes as a credit. This credit is designed to avoid the taxing of the same income by both the foreign country and the United States.
Reporting Worldwide Income:
U.S. citizens and resident aliens are obligated to report their worldwide income on their U.S. tax returns annually. This includes income earned within the United States and any foreign income received during the tax year. Various income sources, such as salaries, wages, dividends, and rental income from outside the United States, fall under the purview of this reporting requirement.
Foreign Earned Income Exclusion (FEIE):
The Foreign Earned Income Exclusion is a provision that allows qualifying individuals to exclude a specified amount of their foreign-earned income from U.S. taxation. To be eligible, one must live and work in a foreign country. IRS Form 2555 is used to claim this exclusion, with the excluded amount prorated based on the percentage of days spent outside the United States.
Foreign Tax Credit Mechanism:
The article rightly highlights that some taxpayers might face double taxation—paying income tax to both the country of residence and the United States. The IRS provides relief through the Foreign Tax Credit (FTC) or deduction. Taxpayers can choose between deducting the foreign income tax paid or claiming those taxes as an FTC. Generally, claiming the foreign tax credit is more advantageous in terms of saving money.
Reporting Foreign Assets:
Apart from income, individuals may need to report their foreign assets to the IRS using Form 8938. This includes financial accounts and ownership interests in non-U.S. entities. Thresholds for reporting vary based on filing status and whether one lives in or outside the U.S.
Reporting Foreign Bank Accounts:
The article emphasizes the obligation to report foreign bank accounts, including bank accounts, brokerage accounts, and mutual funds, through FinCEN Form 114 (FBAR). Failure to file FBAR can result in significant penalties, and timely submission is crucial to avoid legal consequences.
Automatic Tax-Filing Extension for Those Abroad:
Lastly, the article mentions that individuals living abroad can obtain an automatic tax-filing extension, providing flexibility for those who may need additional time to meet their tax obligations.
In conclusion, the taxation of foreign income involves a nuanced set of rules and regulations, and seeking guidance from a qualified tax professional is strongly recommended for individuals who have worked, lived, or invested abroad during a tax year.
