How do the foreign earned income exclusion and foreign tax credit work for 2025 filings?
Executive summary
The Foreign Earned Income Exclusion (FEIE) lets qualifying U.S. taxpayers exclude up to $130,000 of foreign-earned income for the 2025 tax year by filing Form 2555, subject to residency or physical-presence tests and proration rules [1] [2]. The Foreign Tax Credit (FTC) instead reduces U.S. tax liability dollar-for-dollar for foreign income taxes paid and can be used on income that is not excluded, but taxpayers cannot claim a credit for foreign taxes paid on income excluded under FEIE [3] [4].
1. What each tool does and when it applies
The FEIE reduces taxable income by excluding qualifying earned wages or self-employment income earned for services performed abroad, with the 2025 maximum exclusion set at $130,000 and housing relief available through separate foreign housing exclusion or deduction rules [1] [5]. The FTC reduces U.S. tax owed by crediting foreign income taxes actually paid or accrued against U.S. tax liability, preventing double taxation on the same income when the FEIE is not applied to that income [6] [7].
2. Who qualifies and how to prove it
To claim FEIE a taxpayer must have a tax home in a foreign country and meet either the bona fide residence test or the physical presence test (330 full days in any 12‑month period), and U.S. resident aliens may qualify under treaty and residency rules as described by the IRS [5] [2]. Qualification and the details of timing, days present, and intent are documented on Form 2555 and IRS Publication 54, which the IRS uses to determine eligibility once Form 2555 is filed [1] [6].
3. Interaction between FEIE and the Foreign Tax Credit
Once FEIE is elected, taxpayers cannot take a credit or deduction for foreign income taxes paid on the income they excluded, although they may claim FTC on any foreign-earned income that exceeds the exclusion or on other non‑excluded foreign income [3] [4]. The taxpayer may therefore blend strategies—exclude up to the FEIE cap and use the FTC for excess or passive income—but the election mechanics and revocation rules can lock taxpayers into choices with consequences [3] [2].
4. Practical limits, proration and self‑employment tax
The FEIE amount is prorated for qualifying days when a taxpayer is not eligible for the full year, calculated as the lesser of foreign earned income or the maximum exclusion multiplied by the ratio of qualifying days to days in the year, and Form 2555 directs that computation for 2025 [1] [2]. Self-employment tax is not reduced by the FEIE—the exclusion reduces income tax but does not eliminate U.S. self‑employment tax exposure, and the exclusion is effectively reduced by half of self‑employment tax for computation purposes per IRS guidance summarized in public tax guides [5] [2].
5. Election mechanics, revocation and filing consequences
The FEIE must be claimed on a timely filed return with Form 2555 (or via allowed late elections in narrow circumstances), and revoking the FEIE has a five‑year re‑election restriction without IRS approval, so electing or revoking requires deliberation and sometimes an amended prior-year reporting adjustment [2] [4]. Publication 54 and the Form 2555 instructions warn that claiming exclusions affects eligibility for other credits such as the earned income credit and the additional child tax credit, and taxpayers must adjust related prior filings if necessary [3] [4].
6. Strategy and tradeoffs to consider
Choosing FEIE versus FTC depends on income composition, the level of foreign taxes paid, housing costs, and whether exclusion of income would forfeit more valuable credits or create unfavorable results for self‑employment or retirement contribution calculations; professional guidance and careful use of Form 2555 and Form 1116 (for FTC) are common for complex cases [7] [8]. Public expat‑tax guides underscore that high foreign tax rates often make the FTC more attractive for amounts above the FEIE cap, while the FEIE is valuable for many whose foreign wages fall below the limit [8] [7].