The FEIE has no sunset after the OBBA. Is it always the right choice?

The OBBA retained the FEIE without change, which is very useful for many Americans abroad. Overseas voters are generally tied to their last US voting residence rather than represented as a separate overseas constituency. There is no Representative or Senator elected specifically by "Americans living in Germany" or by Americans abroad as a group. Our votes are spread among states and congressional districts across the country.

That makes it reassuring that one of the tax provisions most closely associated with living abroad is not sitting on a recurring expiration date. This is separate from the continuing discussion around residence-based taxation. The US still taxes its citizens on worldwide income, and the FEIE remains one of the tools available within that system.

FEIE should not become an automatic choice

The fact that the FEIE is settled law makes it easy to treat Form 2555 as something you simply carry forward every year. We see that fairly often. A taxpayer used the exclusion when they first moved abroad, it worked, and nobody revisited the decision.

For many people, that is perfectly fine. For others, the Foreign Tax Credit on Form 1116 produces a better result.

The two approaches get there differently. With the FEIE, you report your foreign earned income and then exclude qualifying income, up to the annual limit. With the Foreign Tax Credit, the income remains taxable on the US return, but qualifying foreign income taxes can offset the US tax attributable to foreign-source income.

For someone living in Germany, that distinction matters because German income tax is often high enough to eliminate the US tax liability through foreign tax credits alone. If both methods leave you owing no US income tax, the next question is what each method does elsewhere on the return.

Families should look at the child tax credit

One of the clearest examples is the Additional Child Tax Credit.

If you claim the Foreign Earned Income Exclusion on Form 2555, you cannot claim the refundable Additional Child Tax Credit for that year. This applies even when you exclude only part of your foreign earned income.

For a family with qualifying children, that can turn what looks like a routine FEIE election into a fairly expensive choice. Using the Foreign Tax Credit instead may preserve the refundable credit while still reducing the US income tax liability to zero.

Switching methods also deserves some planning. Once you revoke an existing FEIE election, choosing it again within the next five tax years generally requires IRS approval. It is better to compare the options before making the switch than to discover that rule afterward.

The IRA issue is easy to overlook

IRA contributions are another reason to look beyond the current year's tax bill.

The general IRA contribution limit is tied to compensation included in gross income. Under the rules described in IRS Publication 590-A, foreign earned income excluded under §911 does not count as compensation for this purpose. If you exclude all of your qualifying compensation and have no other eligible compensation, that can leave you without contribution room for a Traditional or Roth IRA.

Using the Foreign Tax Credit instead keeps the foreign wages in gross income. Depending on the rest of the return, that can preserve the compensation needed to make an IRA contribution.

For someone living abroad for ten or twenty years, the ability to continue funding US retirement accounts can matter considerably more than which form eliminated the US tax in a particular year.

Foreign tax credits can also follow you into later years

There is another difference that usually gets less attention. Excess Foreign Tax Credits may be carried back one year and carried forward for up to ten years.

Suppose your German taxes are substantially higher than the US tax attributable to the same income. You may use only part of the available credit this year, with the excess carried forward. If you later move to a lower-tax country while continuing to earn foreign-source income, those carryforwards may become useful.

They are not a general bank of credits against any future US tax. The Foreign Tax Credit limitation still applies, as do the separate income categories on Form 1116. But a carryforward created during several high-tax years can have genuine value when your circumstances change.

The FEIE does not create a comparable carryforward.

What we look at before choosing

There is nothing wrong with the FEIE. For many Americans abroad, particularly those living in countries with low income taxes, it remains an excellent option.

Germany is different. Because German taxes are often high relative to the corresponding US liability, we frequently find that both the FEIE and the Foreign Tax Credit can eliminate the immediate US tax. At that point, the decision becomes less about this year's balance due and more about everything else affected by the choice.

Children, IRA contributions, existing Foreign Tax Credit carryforwards and future relocation plans can all change the answer. So can a change in salary or family circumstances. An approach that made sense when you moved abroad five years ago may no longer be the one we would choose today.

The FEIE having no expiration date is good news. It means the provision is there when we need it. It does not mean we need to use it every year.

If you have been filing Form 2555 for years without comparing it to the Foreign Tax Credit, it may be worth running the numbers both ways before the next return is filed. We do that comparison regularly for our clients, particularly here in Germany where the difference can extend well beyond the tax due on April 15.

This post is intended for general informational purposes and does not constitute tax advice. Please consult a qualified tax professional (like us!) regarding your specific situation.