Citizens and residents of the United States are required to pay taxes on their taxable income. Whether you live in the US or abroad, you are required to file your taxes if you are receiving personal income such as salary, wages, commissions, certain inheritance, royalties and other payments. You may qualify for a tax exemption, which reduces your taxable income but the exclusion is only available for wages earned for services performed outside the US. This article looks at the amount of foreign income that is considered tax free and how they are determined.
Foreign Earned Income Exclusion
An individual’s tax home must be outside the US to qualify for the exclusion and they must meet either the bona fide resident or the physical presence test. The first test applies to legitimate citizens who have lived in another country during the period including a complete US tax year. For physical presence, you are required to be in a foreign country for at least 11 months in any 12-month period that starts and ends in the full US tax year.
The foreign income that is considered tax free for the tax year 2019 is $105,900 and is expected to increase in future years as indexed for inflation. Housing expenses that exceed 16 percent of the exclusion limit is referred to as a separate housing exclusion. It is limited to a specific amount of dollars based on the housing location and number of qualifying days. The amount of foreign income that is considered tax free is only limited to the income earned by a taxpayer for any services performed outside the U.S. However, the income must be apportioned if it relates to services both inside and outside the United States.
How Tax-Free Foreign Income is Determined
If you qualify for American citizenship and you have been living abroad for at least one year, then there are two ways you can reduce your US tax. This includes the Foreign Tax Credit and the Foreign Earned Income Exclusion. However, neither of the two methods exempt you from filing if your income is below the above threshold. Using IRS form 2555, the amount of foreign income that is considered tax free for the tax year 2019 filing in 2020 is $105,900. This means that if you earned $130,000 in 2019, then you need to subtract $105,900 leaving you with $24,100 as taxable by the US at your marginal tax rate. This exclusion only applies to foreign earned income and US citizens who meet the physical presence test and resident test for qualification.
A foreign tax credit can substantially reduce your US tax bill using IRS Form 1116. It allows you to subtract tax that was charged from your income by a foreign country from your US tax. However, a foreign tax credit can only be claimed on foreign taxes from the same income taxed by the US. The ratio of foreign taxes used as a tax credit is established using the fraction of your non-excluded income to total income. When applying for the foreign tax credit or foreign earned income exclusion, it is a must to file your US tax forms regardless of whether your tax bill is zero.
If your foreign earned income is more than $105,900, then you can explore the possibility of using foreign taxes as credit for US taxes that may be due. However, if your foreign income is lower than $105,900 then you can reduce your US tax on your income to zero using the foreign earned income exclusion.
Foreign Bank Accounts
Although the government of the US does not tax bank balances, it is still important for the IRS to be aware of any foreign bank accounts you possess especially if it produced payments such as capital gains or interest. The Foreign Bank Account Report (FBAR) and the Foreign Account Tax Compliance Act (FATCA) are reporting requirements for foreign bank accounts. Foreign banks or financial institutions may be required to report to the IRS information about any accounts held by US persons in a particular country.
These exclusions are only limited to the amount of income earned by a taxpayer for services performed outside the US including salary, and bonuses. Failure to disclose full information about your taxable income can attract penalties. It is important to understand the amount of foreign income that is considered tax free so that you can be aware of the tax that should be due on your taxable income.