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**I have written an update to this with a link to it at the end of this article - Read it Too!**
The Foreign Earned Income Exclusion is a wonderful tax benefit that is available to Americans working abroad. Unfortunately, many employers and employees are unwittingly over-stating the benefits and applicability of the rules with devastating consequences. The over-riding myth is, "You're working overseas - that means you're exempt from taxes on the income!" Some employers actually use the exclusion as a recruiting tool, touting the tax benefit as an exemption from all taxes.
This is not really true. When using the exclusion, it is important to understand the limits and qualifications. You can generally accept a big employer with lots of foreign employees assertion that you will qualify (though you can't hold them accountable if you don't.) I will assume for this article that you will qualify if you stay with your employer. I want to focus on the pitfalls that you run into even if you do qualify. Here they are:
Staying Qualified: Even if you and your employer set you up for qualification, you still, at a minimum, have to spend 330 out of a 365 day period overseas. If you fail to do this, even for very good reasons, you will lose the exclusion, and all your income will be taxable. There is only one real way out of this: being forced to leave due to adverse conditions. The IRS specifically lists those places, and there are very few! Don't assume just because some IED's went off near your place of work that you can pack up and go home. A commenter has pointed out, correctly, that you can also meet the requirements for the exclusion via the Bona Fide residence test, but this one is in may ways even more restrictive - see the comments for more info and a useful link.
Filing Deadlines: That 365 day period above affects this too. If your first year ends after 4/15, you won't meet the test by the filing deadline. You can get an automatic extension to 10/15, but you may need to file form 2350 if your year ends after that. If you don't you could be subject to interest and penalties.
The Big One - There's a MAX: The maximum credit is $92900, plus some housing expense if you have to pay for housing. Let's assume housing is not an issue. If you go overseas on 10/2/2011, you only have 90 days overseas in 2011, so you only get 90/365 x 92900 or $22906 of exclusion. Anything more than that is taxable! Even with 365 days in the tax year overseas, anything over $92900 is taxable.
The Tax Rate Can Be Higher: You figure taxes on any remaining income at the tax rate as if the exclusion was not taken, so whatever income is left after the exclusion is taxed at a higher rate. Also, if you have another job, or your spouse works, their withholding might be inadequate even if you get the full exclusion.
It Limits Other Credits: No Earned Income Credit or Foreign Tax Credit on the same income.
Other Issues: Taking the Exclusion is an election that can be revoked, but can affect other opportunities later. They are too complex for this article, but you need expert advice if you plan on working or living abroad for a long time. You also need to make sure your state honors the exclusion (I did not research this specifically, even though I think all of them do in one form or another.)
Be very careful. Your employer may ask you to fill out Form 673 (or equivalent) to exempt your income from withholding. This is what this whole article is trying to protect you from. If you file that form and you make more money than the exclusion covers, return before meeting the testing period, or have to file a tax return before meeting the test for other reasons (college financial aid, home buying) you could have a HUGE tax bill. I recently prepared taxes for a man who made $150,000 working overseas. He received the full exclusion and still had a Federal tax bill of over $20,000!
If you know you will make less than the exclusion, you're confident you will meet the test, you have no other significant income, and you can wait to file until you meet the test, go ahead and go exempt if you want. Otherwise, let them withhold and get the big refund later.
IRS Pub 54