What You Need to Know About the Foreign Earned Income Exclusion

Foreign Earned Income Exclusion
©iStock/Michael Burrell

You’ve probably seen promises that if you move overseas, you won’t have to pay US income tax.

It’s true. I didn’t pay any US income tax between 1984 and 2007. I’m not paying any US income tax now, either.

That’s because all my income came from work done outside the United States. Now that I’m back in South Africa full time, that’s true once again.

Americans are unique in that we’re taxed on our global income. But that can be unfair to expats. That’s why Congress enacted the Foreign Earned Income Exclusion (FEIE).

As the name implies, the FEIE is an actual income exclusion. If you meet the conditions, the IRS disregards up to $256,000 of income for a couple filing jointly for tax purposes. It’s as if you had never earned it. (The figure is half that for a single person.)

Sounds great! But it’s important to understand the details.

The FEIE only applies to earned income. That means salary, wages, commissions, freelance income, or profit from a business managed from abroad.

Unearned income—pension, interest, rent, dividends, and capital gains—doesn’t qualify.

The thing that makes your income “foreign” isn’t who pays you, or where your bank account happens to be. It’s where you do the work. For example, I work primarily from my office at my home in Cape Town. The fact that I work for a company based in Baltimore and am paid in US dollars into a US bank account is immaterial.

To qualify, you must either be a bona fide resident of a foreign country for an entire tax year, or you must be physically present in one or more foreign countries for at least 330 days in a 12-month period.

That’s the tricky part. To pass the bona fide residence test, you must live primarily in a foreign country. But it’s not enough just to be there physically. It must be the place where your life is focused. The IRS will look for things like bank accounts, utility bills, social connections, kids in school—anything that proves that you’re a resident of the place, not just passing through.

The other way to qualify is by being a “perpetual traveler.” Most countries allow tourist visits for 90 days at a time. Perpetual travelers spend three months in one country, three months in another, etc., until they have spent a total of 330 days outside the US.

It sounds crazy, but the IRS really means it when they say 330 days. There’s a set of rules that talks about what happens if you happen to be flying over the ocean on day number 330, if you happen to set foot on US territory like Guam or Puerto Rico, and so on.

If you qualify for the FEIE, you’ll need to submit Form 2555as part of your federal tax return. You only need to do this once. As long as you continue to qualify for the FEIE, you don’t have to submit it again.

Of course, you will still be liable for tax in the country where you live, as I am here in South Africa. If you really really hate paying income tax, the ideal scenario is to live in a country that doesn't have one and qualify for the FEIE. As long as your income is under the threshold you won't pay any income tax to anyone.

There's one caveat. Because the FEIE excludes foreign earnings from your taxable income, it can’t be used as the basis for retirement contributions. Unless you make substantially more than the FEIE limits, in which case you’ll pay tax on the extra money, you can't contribute to an IRA or a 401K.