Foreign Earned Income Exclusion

What is the Foreign Earned Income Exclusion?

The United States taxes its citizens on worldwide income, but if you live and work outside of the U.S., you may be able to exclude some of your income from taxation by using the Foreign Earned Income Exclusion.

For 2023 the exclusion allows $120,000 of foreign-earned income to be reported free from U.S. taxation. To qualify, you must meet one of two tests: the Physical Presence test or the Bona Fide Residence test.

Do I Pass the Physical Presence Test?

To pass the Physical Presence test you must spend 330 days during a 12-month period present in a foreign country. The 330 days don’t have to be consecutive, they don’t have to be for employment purposes, and they can be spread across multiple countries.  Your tax home also needs to be in a foreign country (more on that below).

To pass the Physical Presence test you must meet all three of the following requirements:

1. Your tax home must be in a foreign country.
2. You must have foreign earned income.
3. You must be a U.S. citizen or 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.

Do I Pass the Bona Fide Residence Test?

For the Bona Fide Residence test you must be a resident in a foreign country for an uninterrupted period that covers an entire tax year. This one is tricky because it is based on intent, not just the type of visa you hold or your immigration status in the foreign country.

To pass the Bona Fide Residence test you must meet all three of the following requirements:

1. Your tax home must be in a foreign country.
2. You must have foreign earned income.
3. You must be:
   • 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. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.

The term bona fide resident is subjective and depends on your answers to questions such as:

• Am I residing in this country for the long-term (longer than one-year)?
• Is my family living here with me?
• Am I legally authorized to stay in this foreign country?
• Do I own a business or am I employed by a company here?
• Do I participate in the tax and social benefit programs in this country?
• Do I have stronger economic and familiar ties here, than in the United States?

If your answer to these question is yes, then you likely qualify as a bona fide resident of a foreign country.

How Do I Establish a Tax Home in a Foreign Country?

To qualify for the Foreign Earned Income Exclusion under the Physical Presence test or the Bona Fide Residence test, you must establish a foreign tax home. This is way easier than it sounds.

The IRS defines your tax home as: “your regular or principal place of business, employment, or post of duty, regardless of where you maintain your family residence…your regular place of abode (the place where you regularly live).”

Basically, your tax home is where you regularly live and work. Live and work in a foreign country, your tax home is in a foreign country. With one caveat…

Again, from the IRS: “You aren’t considered to have a tax home in a foreign country for any period during which your abode is in the United States.”

Alright, got it. I can’t have an abode in the United States… what does that mean? If you own a house, rent it out. If you own a car, sell it or put it in storage. If you have a family or pets, its best to bring them with you. These three things are by no means an exhaustive list, but it’s certainly difficult to argue your abode is outside the United States, if your house and family are still there.

What If I Qualify for Both the Physical Presence Test and The Bona Fide Residence Test?

As with everything tax related, the answer will depend on the specifics of your situation but in general:

If you’re certain that you pass the Bona Fide residence test, it is to your advantage to claim it. It will free you from having to worry about spending 330 days outside of the United States.

However, if there is any doubt whether you qualify as a bona fide resident, stick with the Physical Presence test. Since it’s not subjective, it’s clear and easy to know if you pass and therefore the IRS is a lot less likely to ask questions and challenge you.

What is Foreign Earned Income?

To be excluded under the Foreign Earned Income Exclusion, income must be earned during the period in which you have a foreign tax home and qualify under either the Physical Presence test or the Bona Fide Residence test.

It includes: wages, salary income, and self-employment income.

It doesn’t include: pension income, distributions from retirement accounts, Social Security, interest, dividends, or capital gains.

My Income is Excluded, Do I Even Need to File Taxes?

When domestic taxpayers don’t meet the filing threshold or have any income withheld, they can decide not to file taxes for that year. Taxpayers abroad don’t have that luxury.

If you don’t owe taxes because you qualify for the Foreign Earned Income Exclusion, you must proactively file your taxes to claim the exclusion or you risk losing it. To qualify, the exclusion must be claimed as part of one of the following:

1. A timely filed return.
2. A return amending a timely filed return.
3. A return filed late (but within 1 year of the original due date).

Make sure you are proactive and claim what is rightfully yours! The exclusion is voluntary, so if you don’t file a return to claim it and the IRS audits you, they won’t allow you to exclude your foreign earned income even if you qualify.

How Does the Foreign Earned Income Exclusion Work for Married Taxpayers?

Married taxpayers may be able to exclude up to $240,000 (2023 figure) from their income using the Foreign Earned Income Exclusion. Each person is subject to the Physical Presence Test or Bona Fide Residence test independently. Therefore, it’s possible for married couples to qualify for the same test, different tests, or for one to qualify for the exclusion while the other does not.  If only one spouse qualifies, only their foreign earned income will qualify for the exclusion and it will be limited to $120,000 (2023 figure). When it comes to the Foreign Earned Income Exclusion it’s almost like you’re filing separate returns (almost).

Can I Make a Roth or Traditional IRA Contribution if I Qualify for the Foreign Earned Income Exclusion?

To contribute to a Roth or Traditional IRA, you (or your spouse) must receive taxable compensation during the year. Unfortunately, any income that is excluded under the Foreign Earned Income Exclusion does not qualify as taxable compensation.

This does not automatically mean that you can’t contribute to an IRA, but it does create a very small window of opportunity. Your foreign-earned income must be above $120,000 (2023 figure), so that a portion is included in taxable compensation, yet below (before incorporating the Foreign Earned Income Exclusion) the threshold that disqualifies you from making IRA contributions based on your filing status and employer retirement plan coverage.

Do Digital Nomads Qualify for the Foreign Earned Income Exclusion?

Digital nomads absolutely can qualify for the Foreign Earned Income Exclusion. Most digital nomads can easily pass the Physical Presence test with the right planning.

I Work Remotely for A U.S. Employer, How Do I Adjust My Tax Withholding for the Foreign Earned Income Exclusion?

There’s a form for that: Form 673, Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion Provided by Section 911. This form authorizes your employer to adjusted your withholding in consideration of you obtaining the Foreign Earned Income Exclusion and the Foreign Housing Exclusion.

While this form will reduce the amount of income taxes being withheld, your employer will continue to withhold payroll taxes (Social Security and Medicare). Payroll taxes are unaffected by the Foreign Earned Income Exclusion and apply regardless of where you perform the services if it is for a U.S. employer.

Do You Have Questions About the Foreign Earned Income Exclusion? Leave Them in the Comments Below!

Resources and Tax Forms:

• IRS Summary: Foreign Earned Income Exclusion
• IRS Form 2555: Foreign Earned Income
• IRS Form 2555: Instructions
• IRS Form 673: Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion Provided by Section 911
• IRS Tax Guide for U.S. Citizens and Resident Aliens Abroad
• Contributions to Individual Retirement Arrangements (IRAs)