What is the difference between the Foreign Earned Income Exclusion and the Foreign Tax Credit?
I am a US Citizens living abroad. I am in the process of filing tax return for 2008 for foreign earned income based on IRS' publication 54. Our earned income has already been taxed once by the country we live in.
I see that there are two ways to avoid double taxation on your income -the foreign earned income exclusion and the foreign tax credit.
Can somebody please explain the difference between the two and point out advantages to use one over another?
There's no rule of thumb.
Try the tax return "both ways."
If you qualify for form 2555, try the return with income excluded. If your income is higher than the amount excluded, you can also use form 1116 for the excess.
Even if you qualify for form 2555, try the tax return without it, using form 1116 for all income.
The 2555 is stacked. The excluded income uses up the lowest tax brackets and if you have any remaining taxable income, it's taxed at the highest tax bracket, often starting at 25%.
The 1116 uses averages. As in, if 50% of your income is foreign source, then 50% of your tax bill is foreign source and eligible for the tax credit for taxes paid to the other country.
If I lived in Canada, whose tax structure is higher than the US, I'd probably use 1116 unless my income was entirely below the exclusion amount.
1