Updated with figures for 2014 tax returns.
Just a reminder for Americans who have foreign income: you must declare all foreign income on US income tax returns. For most language assistants, for example, this often simply means including the assistant income on line 21 of Form 1040 as “other income.” This will increase the adjusted gross income, however, and if it is more than $10,150 (if you are single and under 65), you must file tax returns and you might have to pay taxes – unless you have other deductions besides the standard of $6,200 (if you are single) or other exemptions besides the standard of $3,950 (if you have no dependents). Even if your adjusted gross income is less than $10,150, your taxable income is 0 and you are not required to file, it is still a good idea to do so to reduce your risk of audit in the future.
You will also need to check Yes on line 7A of Schedule B to acknowledge that you have a foreign bank account, and you will need to include the amount of interest earned on all domestic/foreign bank accounts on line 1. If if at any point during the year, the amount of your foreign bank account was $10,000 or more, you must also submit the FBAR form online at the BSA E-Filing System. Unlike income tax which is due by April 15, you have until June 30 to submit this form – however, Schedule B should still be submitted with your 1040 by April 15.
If you paid income taxes in another country, you might be able to use the Foreign Tax Credit (Form 1116). You can either claim a credit for eligible foreign taxes or deduct foreign income taxes. If you did not pay taxes on your foreign income, such as language assistants who do not make enough to be taxed in France or students who received a tax-free scholarship to study in another country, you may be able to use the Foreign Earned Income Exclusion (Form 2555). However, in order to claim this exclusion, you must be in the foreign country for at least 330 days of a twelve month period. This means that most assistants do not qualify, unless you were able to renew your position and did not return to the US for more than 35 days the entire year.
If you are able to claim the Foreign Earned Income Exclusion, Form 2555 is quite simple to fill out. This form doesn’t explicitly tell you to put your foreign income on line 7 of Form 1040 though, so just add it to other wages, salaries, etc. if you need to. You will then subtract it out on line 21 where you put the same amount in parentheses and write Form 2555 on the line to the left. When claiming the exclusion, your foreign income does NOT increase your adjusted gross income, but it WILL increase the amount of tax you need to report on line 44 of Form 1040 (if your taxable income is more than 0). Your taxable income is often your adjusted gross income minus $10,150 ($6,200 for the standard deduction on line 40 and $3,950 for the exemption on line 42) if you are single with no dependents.
If you read the instructions for Form 1040, the very last paragraph for line 44 states: “If you claimed the foreign earned income exclusion, housing exclusion, or housing deduction on Form 2555 or 2555-EZ, you must figure your tax using the Foreign Earned Income Tax Worksheet.” The worksheet is on the next page and it basically instructs you to figure out the tax rate of your taxable income (line 43 on Form 1040) PLUS your foreign income (from Form 2555) and then subtract out the tax rate for your foreign income alone. Essentially this pushes your taxable income into a higher tax bracket as it will be higher than if you just look up the tax rate for your taxable income alone. If you also have qualified dividends, then you must use the Qualified Dividends and Capital Gain Tax Worksheet in order to figure out the correct number to put on line 4 of the Foreign Income Tax Worksheet. So simple, right?
If you only have foreign income and you are able to deduct all of it, then your taxable income will be 0 so you don’t need to worry about using the Foreign Earned Income Tax Worksheet or paying taxes. However, if you have both US and foreign income (such as self-employed Americans who also work at a different job abroad), you will end up paying more in taxes than if you had only foreign income. Let’s say you have $5,000 for your taxable (NOT adjusted gross) income on line 43 of Form 1040 and $10,000 for your foreign income. You would put 10,000 on line 7 of Form 1040 and (10,000) on line 21. But when you get to line 44, you’ll have to use the Foreign Earned Income Tax Worksheet found in the 1040 instructions. Assuming you are single and do not have qualified dividends, this is how the worksheet would look:
1. Taxable income from Form 1040, line 43 = 5,000
2. Foreign income from Form 2555, line 50= 10,000
3. Add lines 1 and 2 = 15,000
4. Tax on amount of line 3 = 1,800 [look up 15,000 in tax table in 1040 instructions]
5. Tax on amount of line 2 = 1,050 [look up 10,000 in tax table]
6. Subtract line 5 from line 4; include this amount on Form 1040, line 44 = 750
So you would have to put $750 for the amount of your tax. If you did not read the instructions and did not use the Foreign Earned Income Tax Worksheet, you would have simply looked up the tax rate for your taxable income of $5,000, which is $503. But thanks to your foreign income, you must instead pay $750. Even though you can exclude your foreign income from your adjusted gross income, you may still end up paying more taxes. Isn’t being an American expat great?
Be wary of the Free File websites as many do not report foreign income correctly (and you can’t use the majority of them anyway if you no longer live in the US). I tried some of them and a few didn’t even include foreign income on the 1040 while others only included the amount in parentheses on line 21 so the adjusted gross income was a negative number. I was also unsuccessful in submitting the forms electronically – even simply using Free Fillable Forms – since I am still living abroad and cannot put an end date under the Bona Fide Residence part, which creates errors and a rejection of the file. So if you’re still abroad, you may end up mailing the paper forms to Texas (if you’re not including payment) or North Carolina (if you are including payment).
Disclaimer: I am not an accountant or tax specialist so if you have questions about your return, contact the IRS.