Do Foreigners Have to Pay Taxes? Your Guide to Foreign Earned Income

When it comes to taxes, things can get complicated fast, especially if you’re dealing with foreign income. Whether you’re a U.S. citizen working abroad or a foreigner earning money in the U.S., staying on top of your taxes is essential. You don’t want to be hit with unexpected bills or penalties just because you missed a crucial detail.

Luckily, there are ways to make the process easier. From foreign income exclusion that reduces the amount of income, you’re taxed on to a US foreign tax credit that prevents you from being taxed twice. Understanding the right strategies can save you a lot of money and stress. Ready to learn how to keep more of your hard-earned money in your pocket? Let’s dive in.

What is Foreign Income?

Foreign income, as the name suggests, is any money you earn from outside the U.S. This can come from many sources, like:

• The money you make from working abroad
• Bonuses or allowances from a foreign employer
• Earnings from your own business in another country
• Interest from foreign bank accounts or investments
• Dividends from foreign companies
• Profits from selling property or investments overseas
• Income from renting out a house in another country
• Money from foreign businesses or partnerships you’re part of
• Other types of foreign income, like royalties, alimony, or even gambling winnings

What is Foreign Earned Income?

Foreign earned income is specifically the money you make by working or running a business while living in another country. This includes:

• Salaries and wages from working abroad
• Bonuses you get for your work in another country
• Income from your business in a foreign country

The main difference between foreign-earned income and other types of foreign income is that foreign-earned income comes from your job or business abroad, and it qualifies for a tax break called the Foreign Earned Income Exclusion (FEIE). Other types of foreign income, like investment income or rental income, don’t qualify for this tax benefit and are taxed differently.

Also Check-Out: Mastering Foreign Tax Credits: Your Comprehensive Guide

Paying U.S. Taxes While Working Abroad

For U.S. citizens earning income while working overseas, the U.S. tax system still requires you to pay taxes on your foreign income. Unlike most countries, the U.S. taxes its citizens based on their citizenship rather than their residency. 

This means that even if you live and work in another country, but are a U.S. citizen or permanent resident, you’ll still need to report and pay taxes on your foreign-earned income.

To help ease the tax burden, the IRS offers tools like the Foreign Income Exclusion and the Foreign Tax Credit (FTC), which can reduce the amount of tax you owe. The FEIE allows you to exclude a portion of your foreign-earned income from U.S. taxes, while the Foreign Tax Credit helps offset the taxes you may have already paid to the country where you’re working.

Who Qualifies as a Foreign Person for U.S. Tax Purposes?

A foreign person can be any of the following:

• An individual who is a nonresident alien
• A corporation based outside the U.S.
• A partnership formed under foreign laws
• A trust or estate established in another country
• Any entity or person who is not classified as a U.S. person

How to Report Foreign Income on Your U.S. Taxes?

If you’ve earned income while living abroad, follow these steps to report it to the IRS:

• File IRS Form 1040: This is the primary form for reporting foreign income.
• Wondering where is foreign earned income exclusion on 1040? To claim the exclusion, you must attach Form 2555 to your Form 1040. The exclusion is reported on line 8d, which reduces your taxable income.
• Include Additional Forms if Necessary:
  • FBAR (FinCEN Form 114): Report foreign bank accounts if they exceed certain thresholds.
  • FATCA Form 8938: Report foreign assets, such as investments or properties.

For freelancers or contractors working overseas, you’re considered self-employed. This means:

• You still need to report your income to the IRS.
• You’ll also be responsible for paying self-employment taxes.

Given the complexity of foreign income tax reporting, it’s a good idea to consult with a tax expert. SWAT Advisors can help you with foreign income exclusions, reporting, and overall tax planning.

Our team also includes an exit planning advisor who will help you transition smoothly out of your business when the time is right, while our tax planning advisor ensures you avoid penalties and maximize your tax savings, securing your financial future.

Have a Look: Do You Need to File a Report of Foreign Bank and Financial Accounts Jointly?

Avoiding Double Taxation on Foreign Income

As a U.S. citizen working abroad, you might worry about being taxed twice—once by the foreign country and again by the U.S. To help with this, the IRS offers two key benefits:

• Foreign Earned Income Exclusion (FEIE)
• Foreign Tax Credit (FTC)

What is Foreign Earned Income Exclusion (FEIE)?

The Foreign Earned Income Exclusion (FEIE) allows U.S. citizens and residents living abroad to exclude a portion of their foreign-earned income from U.S. taxes, helping to prevent double taxation. 

You might be wondering, how much foreign income is tax free in USA? For the 2024 tax year, the answer is up to $126,500 of active income, such as salaries, wages, or self-employment earnings. However, passive income like interest or dividends remains taxable.

Here is the complete data you might want to look at:

Qualifying for the Foreign Earned Income Exclusion

To qualify for the FEIE, you must meet specific residency requirements, which can be determined through one of two tests:

Physical Presence Test

• You must be physically present in a foreign country for at least 330 full days within any 12-month period.
• Your tax home must be in a foreign country, meaning where your work is based, not necessarily your personal residence.

Bona Fide Residence Test

• You need to be a bona fide resident of a foreign country for an entire tax year (January 1 to December 31).
• This test requires proof of long-term residence, such as owning a home or having local financial accounts, and a demonstrated intention to stay abroad indefinitely.

Choosing the correct test depends on your personal circumstances—whether you’re on a temporary work assignment or have permanently relocated abroad.

How to Claim the Foreign Earned Income Exclusion?

To claim the FEIE, you must file IRS Form 2555 with your U.S. tax return. You’ll need to:

• Choose which test you’re using to qualify (Physical Presence or Bona Fide Residence).
• Provide documentation of your foreign-earned income and any international travel dates.
• If you and your spouse both claim the FEIE, each of you must file a separate Form 2555, even if filing jointly.

Requesting an Extension for the Foreign Earned Income Exclusion

If you haven’t met the residency requirements by tax filing season, you can request an extension by filing IRS Form 2350. This gives you additional time to meet the qualifications, especially useful if you’re close to passing the Physical Presence Test but haven’t yet accumulated 330 days abroad.

For example, if you moved overseas in October 2023, you may file for an extension to cover the full 12-month period necessary to qualify for the FEIE in 2024. Extensions help you maximize your tax benefits while ensuring you stay compliant with U.S. tax laws.

Now that it’s clear what is the foreign earned income exclusion, let’s move on to another option, which is a foreign tax credit.

The Foreign Earned Income Exclusion (FEIE) can be tricky, but SWAT Advisors is here to guide you through the process. We’ll ensure you make the most of your tax benefits while staying compliant with U.S. tax laws.

Our services also include financial planning for doctors, addressing the specific needs of medical professionals, and financial planning for real estate agents, helping agents manage fluctuating incomes and plan for a secure future. We’re committed to helping you achieve your financial goals.

What is a Foreign Tax Credit (FTC)?

The Foreign Tax Credit (FTC) helps U.S. citizens and residents who pay income taxes to a foreign country or U.S. possession avoid double taxation. By claiming the FTC, you can reduce your U.S. tax liability by the amount of foreign taxes you’ve already paid on the same income, ensuring you’re not taxed twice on that income.

What Taxes Qualify for the Foreign Tax Credit?

To qualify for the FTC, the foreign tax must meet specific requirements:

• Imposed on You: The tax must be a legal and actual tax liability imposed by a foreign country or U.S. possession.
• Type of Tax: Only income, war profits, and excess profits taxes generally qualify. This includes foreign taxes on wages, dividends, interest, and royalties.
• No Specific Economic Benefit: The tax cannot be a payment for a specific economic benefit received from the foreign government.

Some other taxes, like foreign property taxes or sales taxes, don’t qualify for the FTC but may be deductible as itemized deductions on your U.S. tax return.

Additionally, foreign taxes that are “in lieu” of an income tax can also qualify, even if they aren’t imposed under the country’s income tax law.

When calculating the FTC, you must convert foreign taxes paid in foreign currency to U.S. dollars. You should use the exchange rate in effect on the date the foreign tax was paid, withheld, or when you made any estimated tax payments. This ensures an accurate calculation of the credit amount.

Read More: How Do You Calculate and Pay Estimated Taxes? 

How Does the Foreign Tax Credit Work?

When you earn income abroad and pay foreign taxes on that income, the FTC allows you to offset the U.S. taxes you owe by the amount of foreign taxes you paid. Instead of just lowering your taxable income through an itemized deduction, the FTC directly reduces your U.S. tax bill, which often results in a bigger tax benefit.

To take advantage of the FTC, you typically need to file Form 1116 with your U.S. tax return, where you’ll calculate the credit based on your foreign income and taxes paid. In some cases, if your foreign income is low enough or meets specific conditions, you can skip Form 1116 and claim the credit directly on your Form 1040.

By using the Foreign Tax Credit effectively, you can minimize your U.S. tax liability while complying with both U.S. and foreign tax obligations.

Important Tax Credit Rules

• Use of Deductions: If you choose to deduct foreign taxes instead of taking the credit, you can do so on Schedule A of your tax return. However, once you choose either a deduction or a credit for a particular tax year, you must stick with that choice for all qualified foreign taxes paid that year.
• Carryforward/Carryback: If you cannot use the full amount of your foreign tax credit in one year, you can carry it back to the prior tax year or forward up to 10 years. This flexibility helps you maximize the benefit of the credit.

Choosing Between the FEIE and FTC

While both the Foreign Earned Exclusion and the Foreign Tax Credit can reduce your U.S. tax bill, you must choose between the FEIE and FTC, as you cannot claim both for the same income. It’s important to understand your financial situation to determine which option will benefit you the most:

• FEIE is typically better for those who earn lower to moderate income from work or business abroad and want to reduce their taxable income in the U.S.
• FTC may be more beneficial if you’re paying a high amount of taxes to a foreign government, as it allows you to directly reduce your U.S. tax bill by the amount paid to the foreign country.

If you’re unsure which option is best for your situation, consulting with a tax professional can help you make the right choice and avoid any unpleasant surprises when filing your taxes.

In Closing!

Understanding foreign earned income and its tax implications is not just about compliance; it’s about smart financial planning. Whether you’re a digital nomad or a permanent expatriate, being prepared can make all the difference. 

One common mistake is misunderstanding tax residency, which can lead to unexpected U.S. tax obligations and penalties, even if you’re living abroad. Another frequent misstep is overlooking foreign tax credits, which can help reduce your U.S. tax liability by recognizing the taxes you’ve already paid to foreign governments—ignoring this can cost you more than necessary. 

To avoid these pitfalls and ensure you’re making the most of your situation, it’s always wise to consult with SWAT Advisors. This way, you can protect your hard-earned money and stay on top of your tax responsibilities with confidence.