If you are a U.S. citizen or a resident alien of the United States and you live and work in another country, you have to pay income tax to the local jurisdiction where you actually live and work. And you have to report this income on your United States income tax form as well. The US tax system works on a on a worldwide basis regardless of source and regardless of residency for U.S citizens and green card holders. Congress has provides ways to mitigate the potential double taxation when the same income is taxed in both a foreign country and in the United States, but still keep the part about Americans living anywhere being taxed on worldwide income. US tax law prevents double taxation by allowing you to claim either the:

• Foreign Earned Income Exclusion,
• the Foreign tax credit or
• Deductions for foreign taxes.

Each has its own requirements and amount limit. It is necessary to know which leads to the lower tax under your specific facts and circumstances.

What is Foreign Earned Income Exclusion?

The Foreign Earned Income Exclusion allows United States Citizens and resident aliens who live and work abroad, either as an employee or self-employed in your own business, to exclude all or part of their foreign earned income from their gross income when filing their U.S. federal tax return. They may also qualify to exclude compensation for their personal services or certain foreign housing costs. This tax break is available only to a qualifying individual with qualifying income.

Can I claim the Foreign Earned Income Exclusion?

To claim the foreign earnings income exclusion, the foreign housing exclusion, or the foreign housing
deduction, you must meet all three of the following requirements:

• Your tax home must be in a foreign country
• You must be either:
• A U.S. citizen who is a bona fide resident of a foreign country or countries for an
  uninterrupted period that includes an entire tax year, or
• A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or
  countries for at least 330 full days during any period of 12 consecutive months.
• You must have foreign earned income.

What is foreign Earned Income?

Foreign earned income is income that you receive for services you perform in a foreign country during the period your tax home is in a foreign country. They include:

• Salaries and wages, commissions, bonuses, professional fees, tips
• Noncash income – Fair market value of property or facilities provided by your employer in the form

of the following:

• lodging,
• meals,
• or use of a car
• Allowances or reimbursements – Includes allowances or reimbursements you receive, such as
  the following amounts:
• Cost of living allowance
• Overseas differential
• Family allowance
• Reimbursement for education or education allowance
• Home leave allowance
• Quarters allowance

Exclusion of Meals and Lodging from income only if the following conditions are met:

• The meals are furnished on the business premises of your employer, and for the convenience of your employer.
• Lodging is furnished on the business premises of your employer, for the convenience of your employer, and as a condition of your employment.

If the above conditions are met, do not include the value of the meals or lodging in income. These
exclusions are not foreign earned income, and not included in the total reported on the W-2 in box 1 as
wages.
However, there are items that the IRS doesn’t include as foreign earned income, including:

• Previously excluded value of meals and lodging furnished for the employer’s convenience
• Pay you received as an U.S. Government employee
• Recaptured unallowable moving expenses
• Annuity or pension payments (include Social Security benefits)
• Payments received after the end of the Tax Year following the Tax Year in which you performed the services that resulted in earned income
• Amounts that are included in your income because of your employer’s contributions to a nonexempt employee trust or to a nonqualified annuity contract

How or where you’re paid has no effect on the income’s source. For instance, income you received from work you’ve done in China is income from a foreign source. This applies even if the income is directly paid to your U.S. bank account and your employer is located in US.
If you received a specific amount for work you’ve done in the U.S., you must report that amount as U.S. source income.

What Is the Maximum Amount I Can Exclude From My Foreign Earned Income?

The amount of foreign income that you can exclude is limited to your annual maximum dollar amount limit or actual foreign wages, whichever is less. Since Tax Year 2006, the IRS has adjusted this amount each Tax Year for inflation.

Can I Exclude My Foreign Housing Costs?

In addition to the foreign earned income exclusion, you can also claim exclusion for your housing amount, if your tax home is in a foreign country and you qualify under either the bona fide residence test or the physical presence test. There are limits to the amount that can be claimed as a foreign housing exclusion. The housing exclusion applies only to amounts considered paid for with employer-provided amounts. The housing deduction applies only to amounts paid for with self-employment earnings. Your housing cost exclusion (or deduction) is generally your total foreign housing expenses in excess of a base housing amount, subject to certain limitations.
Housing expenses that qualify for the foreign housing exclusion include:

• Rent
• The fair rental value of housing provided in kind by your employer
• Repairs
• Utilities (other than telephone)
• Real estate/personal property Insurance
• Nondeductible occupancy taxes
• Nonrefundable security deposits or lease payment
• Furniture rental
• Residential parking

Housing expenses do not include:

• Cost of buying property
• Home improvements
• Lavish or extravagant expenses
• Domestic labor
• Deductible property taxes and mortgage interest

How Can I Claim a Foreign Income Tax Exclusion?

The foreign earned income exclusion is voluntary. You can choose the foreign earned income exclusion and the foreign housing exclusion by completing the appropriate parts of Form 2555. Your initial choice of the exclusions on Form 2555 or Form 2555-EZ generally must be made with:

• a timely filed return (including any extensions),
• a return amending a timely filed return, or
• a late-filed return filed within 1 year from the original due date of the return (determined without regard to any extensions).

You can choose the exclusion on a return filed after the periods described above provided you owe no federal income tax after taking into account the exclusion. If you owe federal income tax after taking into account the exclusion, you can choose the exclusion on a return filed after the periods described above provided you file before IRS discovers that you failed to choose the exclusion.
Once you choose to exclude your foreign earned income or housing amount, that choice in effect for that year, and all
subsequent years until you revoke it. You can revoke your choice for any tax year by attaching a statement to your tax return. However, if you revoke your choice for a tax year, you cannot claim the exclusion again for your next 5 tax years without the approval of the IRS.

How Do I limit or discontinue tax withholding for the exclusion?

If you expect to qualify for the foreign income tax withholding under the bona fide residence test or physical presence test, you may be able to have your employer discontinue withholding income tax from a part or all of your wages. You can complete and submit Form 673, or similar Statement to your employer.

What are the tax consequences of foreign earned income exclusion?

You Forgo the Foreign Tax Credit If you claim the exclusion, you would not be able to claim a deduction or credit on your U.S. income tax return for the foreign income tax on your earned income. Once you choose to exclude either foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes you paid or accrued for the tax year. However, you can choose to take the foreign tax credit on any amount of foreign income which has not been excluded under the foreign earned income exclusion or the foreign housing exclusion.

Items Related to Excluded Income If you choose to exclude foreign earned income or housing amounts, you cannot deduct, exclude, or claim a credit for any item that can be allocated to or charged against the excluded amounts. This includes any expenses, losses, and other normally deductible items that are allocable to the excluded income.
These rules apply only to items definitely related to the excluded earned income and they do not apply to other items that are not definitely related to any particular type of gross income. These rules do not apply to items such as:

• Personal exemptions,
• Qualified retirement contributions,
• Alimony payments,
• Charitable contributions,
• Medical expenses,
• Mortgage interest, or
• Real estate taxes on your personal residence.

For purposes of these rules, your housing deduction is not treated as allocable to your excluded income, but the deduction for self-employment tax is.

Tax rate after foreign earned income exclusion You figure taxes on any remaining income at the tax rate as if the exclusion was not taken. The excluded income from gross income is included for determining the applicable tax rate and the excluded dollar is treated as though it were the first dollar of income and taxed at the very lowest tax bracket. This “Stacking” results in the next dollar of income taxed at a much higher marginal rate of tax,, so whatever income is left after the exclusion is taxed at a higher rate. This ensures that U.S. citizens living abroad are subject to the same U.S. tax rates as individuals living and working in the United States.

IRA Retirement Plan contribution You can contribute up to $5000 ($6000 if 50 or over) from taxable compensation. For this purpose, taxable compensation includes wages, salary, tips, professional fees, commissions, self-employment income, non taxable combat pay, alimony and separate maintenance payments. If you have excluded all your income, you do not have any “taxable compensation” and thus are ineligible to contribute to an IRA. One way around this is to choose a 12 month period that will not give you a full exclusion of earned income in the tax year, and leave the un-excluded earned income for contribution to your IRA. Besides, any amount of earned for any days you worked in the US during the foreign assignment is not excludable, and you can make your contribution based this amount.

Child tax credit This credit pays a benefit of $1000 off your tax liability for each child under 17 years old if you make less than the phase-out amount. When you check the qualifications for the child tax credit, it mentions that the child must live with the taxpayer but is not required to be in US. However, if you have excluded all your foreign earned income, you probably owe no income tax after deductions and exemptions, and therefore there leave nothing to be credited. This way you lose $1,000 per child by claiming foreign earned income exclusion. Sometimes, you may even lose more. You may claim additional child tax credit by filing form 8812 if you have taxable earned income.
Modified AGI The IRS uses a method called “Modified Adjusted Gross Income” to determine if taxpayers are eligible for specific deductions, credits and retirement plans. Your foreign earned income or housing excluded or foreign housing deduction taken on 2555 are often added back to your AGI. This may reduce or even eliminate some of tax benefits.

Earned income credit Taxpayers who wish to claim the Earned Income Tax Credit should not claim the exclusion, since they are not allowed to claim both.

When should I choose the foreign earned income exclusion?

Foreign earned income exclusion and foreign tax credit or deduction are two ways to avoid double taxation on your foreign income. Taxpayers may not elect to take both the foreign-earned income and housing exclusions and the foreign tax credit. Also, if a taxpayer claims the foreign earned income exclusion, the taxpayer will not qualify for the earned income credit for that year. The choice between the foreign earned income and housing exclusions and the foreign tax credit depends on which option more effectively reduces taxes.
In selecting the more appropriate option, a taxpayer must also consider factors, such as, length and certainty of stay in a foreign country. If your foreign earned income is under the exclusion amount and you do not have lots of other income, then the foreign earned income exclusion is the simplest and preferred option, if you qualify to use it. But if a taxpayer working in a country where the tax rate is the same or higher than the US tax rate, a detailed calculation of the tax liability using both exclusion and tax credit is necessary to know which leads to the lower tax. Since once the foreign earned income exclusion is chosen, it will be valid for the future year unless the taxpayer revokes the election, he may not take the election for five years without permission from the IRS. Therefore, is important that you have a professional review either your continued eligibility for the foreign earned income and housing exclusion, or the possibility of transfer of high tax countries to low rate countries or adverse.