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What is a foreign tax deduction?

In an increasingly globalized world, more people are seeking and obtaining employment opportunities abroad. This presents a myriad of financial considerations, one of the most important being taxation. Navigating the complex world of international taxation can be challenging, but one concept that significantly impacts expatriate workers is the foreign tax deduction.

Foreign Tax Deduction: An Overview

The foreign tax deduction comes into play when individuals earn income in a foreign country and pay taxes on that income to the foreign government. The purpose of the deduction is to prevent these individuals from being subjected to double taxation - first by the foreign country, and then by their home country. In essence, the foreign tax deduction reduces their taxable income by a portion of the income tax they paid to the foreign government, providing relief from potential double taxation.

Eligibility for Tax Deductions, Credits, and Exclusions

Expatriate workers earning income overseas generally qualify for tax deductions, credits, or exclusions to account for taxes paid on their foreign income. For U.S citizens, the Internal Revenue Service (IRS) offers the choice among these three options. Importantly, although one can combine the exclusion with either a credit or deduction, credits and deductions themselves generally cannot be mixed. Regardless of the number of foreign countries where one earns income within a year, the IRS requires considering foreign income in aggregate.

Choosing Between Credits and Deductions

The IRS usually advises taxpayers that credits are more advantageous because they represent a dollar-for-dollar reduction in domestic taxes owed. In contrast, a deduction only reduces the amount of income subject to taxation. However, there can be instances where a deduction could be more beneficial than a credit, depending on the individual's tax situation. Consequently, everyone is encouraged to compare the two options after computation.

Foreign Earned Income Exclusion and Residential Allowances

The Foreign Earned Income Exclusion allows Americans who have worked abroad to exclude a certain amount from U.S. income taxes. In 2016, this amount was $100,800. If an employee incurs substantial expenses for a foreign residence or receives a residential bonus from their company, they could add an additional amount to the earned income exclusion, sometimes exceeding $30,000. Any income earned over this total exclusion amount may be eligible for credits or deductions if taxes were already paid on that amount overseas.

When to Opt for the Foreign Tax Deduction

The foreign tax deduction is an itemized deduction that American taxpayers can claim to account for taxes already paid to a foreign government. These are typically classified as withholding taxes. Usually, taxpayers opt for the foreign tax deduction instead of the more common foreign tax credit if the deduction is more advantageous. Thus, the decision to take a deduction instead of a credit is heavily dependent on each individual's unique financial circumstances. Understanding the intricacies of foreign tax deductions can significantly impact an expatriate worker's financial wellbeing and tax liability. By taking the time to understand these mechanisms, taxpayers can make informed decisions and potentially save on taxes. It's always advisable to consult a tax professional to help navigate these complex issues and ensure you are maximizing your potential tax benefits.

 

Summary

Workers who earn income in foreign countries will frequently pay taxes on the income in the country in which the wages were earned. In such cases the worker may be eligible to take deductions for the amount of taxes paid so that their entire income is not subject to taxes again in their country of citizenship.

Ex-patriot workers who earn income overseas are generally eligible for tax deductions, credits, or exclusions to account for the taxes that they have already paid on their income in the foreign country.

The IRS gives US citizens who have earned foreign income the choice between the three, and the exclusion can be combined with one of the other two but credits and deductions are generally not allowed to be combined or mixed with regard to foreign income, which must be considered in aggregate, even if you have worked in several foreign countries in the same year.

The IRS advises that credits are normally more advantageous to you, because they constitute a dollar-for-dollar reduction in the amount of taxes owed domestically, whereas a deduction only reduces the amount of income subject to taxes. There are instances where a deduction could be more advantageous than a credit, however, and everyone is encouraged to compare the two options after computing each one. In regards to exclusion amounts, these are usually going to be taken before anything else happens, be it a credit or deduction.

The Foreign Earned Income Exclusion allows Americans who have worked abroad to exclude the first $100,800 (in 2016) from US income taxes, and, if the employee was paying a significant amount for a foreign residence, or if the company was giving a residential bonus amount to the employee, an amount up to (and potentially greater than) $30,000 can be added to the already-taken earned income exclusion.

Any income earned over that $130,000 amount may be eligible for credits or deductions if taxes were paid on that amount overseas already.

What if I Want to Retire Abroad?
What is a Foreign Tax Credit?
What is the Foreign Earned Income Exclusion?

Disclaimers and Limitations

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