If you want to save the most money and reduce your expat income tax, the Foreign Earned Income Exclusion may not be the best choice for you. Surprised? You aren’t alone. Many US expats believe this is the best (and sometimes only) way to avoid US taxes. Follow the journey of one Greenback client who had been using the Foreign Earned Income Exclusion for years but her Greenback accountant showed her there was another way to avoid paying taxes to Uncle Sam–The Foreign Tax Credit.
Charlotte is an American who has been living in Germany for several years. Her German husband actually has a Social Security Number but is a nonresident alien for US tax purposes. They have three young children, all of whom are American citizens by birthright.
For years Charlotte self-filed using the Foreign Earned Income Exclusion and as a result, had no income tax liability in the US. Because of the significant difference in their incomes (his earnings were nearly double hers), she did not file jointly with her husband. In addition, joint filing would have opened him up to tax exposure to the US. She came to Greenback after an error in her self-prepared tax return resulted in the IRS disallowing the use of the Foreign Earned Income Exclusion. She received a notice outlining several thousand dollars of income tax, penalties and interest due.
How Greenback Helped
When her accounted reviewed her situation, she looked closely at her income situation. With three young children and a moderate earned income without any investment income, revoking the Foreign Earned Income Exclusion and using the Foreign Tax Credit allowed her to claim the additional Child Tax Credit, which is $1,000 for each child until each one turns 17. Not all taxpayers with children are eligible to claim the Child Tax Credits; the child(ren) must be under the age of 17, US citizens or permanent residents OR nonresidents who meet the substantial presence test in the United States, and t(he)y must have an SSN or ITIN.
The Child Tax Credits Explained
The Child Tax Credit and additional child tax credit are called family incentive credits. The regular Child Tax Credit is a nonrefundable credit, meaning that it will reduce a person’s income tax liability to zero, but it cannot offset self-employment tax liability or result in a refund. The additional child tax credit is a refundable credit, meaning it is considered to be a payment, just like withholding, against tax. To claim either of the child tax credits, a taxpayer must have taxable income. The Foreign Earned Income Exclusion removes foreign income from taxability but the Foreign Tax Credit does not. This means that taxpayers who use the Foreign Tax Credit maintain the ability to use credits that require taxable income.
Charlotte’s accountant decided to amend all the self-prepared returns in the open period to revoke the Foreign Earned Income Exclusion and claim the Foreign Tax Credit. As a result, she ended up with no expat income tax liability in the US, which she would have had using the Foreign Earned Income Exclusion, but also a net gain of several thousand dollars. Not only did she receive the credits, the IRS also paid her statutory interest on the refund as well.
While every expat situation is unique, it is important to remember that sometimes consulting an expert in US expat taxes can be very useful in ensuring you don’t have a US tax liability. As Charlotte found out, using a professional can not only save money, but actually put money back in your pocket!
Interested in learning about how the Foreign Tax Credit could help you reduce your expat income tax?
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