While legal loopholes for tax-free income are hard to find, there is one obvious exception. It is the Foreign Earned Income Exclusion. While most people will not be able to take advantage of this, for those who can, the following covers exactly what it is, how to qualify for it, why it exists and how to claim it.
The Foreign Earned Income Exclusion allows Americans working overseas to exclude up to $95,100 (for the 2012 tax year) of their earned income from Federal Taxes. Note that this only includes earned qualifying wage and compensation income.
How to qualify for the exclusion
Taxpayers first must be sure they qualify for the exclusion. It can be claimed if one qualifies as a bona fide resident (having resided overseas for the entire tax year) or under the physical presence test (330 days of a 12-month period) and is working overseas. For those working overseas for part of a tax year who intend to remain for at least the 330 days, the amount of their exclusion for the year will be calculated based the number of days spent overseas in that tax year. However, not everyone living and working overseas qualifies, with the most noticeable exception being US government employees.
What is considered earned income
Basically, the exclusion only covers wages and other professional fees received as compensation for services performed while working abroad. Keep in mind that how and where one is paid does not matter but where the work was performed and residency does. However, note that this only covers compensation for work performed. Other income, to include dividends, capital gains, pensions, Social Security payments and the like do not qualify.
Why does the government offer this exclusion?
It can be argued that those working overseas are not using government supplied services and thus should not have to pay taxes for them. However, the reason for the exclusion has more to do with the economics of employing Americans overseas. People working abroad usually have to pay taxes in the nations they work in. For this reason, most nations do not tax their overseas nationals’ income at all. If the US did not offer an exclusion, it would be a big disincentive for Americans to work overseas and make those who wanted to more expensive to employ. Therefore, the earned income exclusion is somewhat of a necessity if Americans are to have the same opportunities to work overseas as others.
What to do at tax time
For those who qualify, claiming the exclusion at tax time is usually relatively straightforward. First, one must fill out Form 2555 or Form 2555-EZ. Form 2555-EZ has fewer lines to fill in but not everyone qualifies to use it under IRS rules. The instructions for Form 2555 help those using it determine exactly how much of their income qualifies for the exclusion. This form must be attached to and submitted with Form 1040 or 1040X. It should not be sent separately. Note that the IRS does not allow electronic filing for those claiming the exclusion.
After Form 2555 is complete, the amount of the exclusion needs to be entered on line 21 of Form 1040 as a negative amount. Since all wages, salaries, tips, etc. including what was earned overseas are entered on line 7, entering what qualifies for the exclusion on line 21 as a negative number will eliminate any money earned overseas under the exclusion from being counted towards taxable income in any way.
Other tax advantages
While other income is still taxable, the money subtracted under the exclusion will reduce one’s overall amount of taxable income and thus the tax bracket for at least part of their other income. For example, those who have capital gains and dividend income only have to pay income taxes on it if the amount earned exceeds their standard deductions, and the amount after the standard deductions is taxed at the bracket it would be if it was the sole income. In other words, the exclusion is also a way to reduce taxes on investment and other forms of income.
For anyone accustomed to doing their own taxes, the Foreign Earned Income Exclusion is not likely to complicate things greatly. However, those claiming it for the first time might want to get expert tax advice or at the very least use tax software to avoid mistakes.