Do I pay US tax on income I earn outside the United States?

US citizens and resident aliens are taxed on worldwide income, including income earned outside the country. Relief exists rather than exemption: someone whose tax home is in a foreign country and who meets the bona fide residence test or the physical presence test can exclude a limited amount of foreign earned income on Form 2555, and a foreign housing amount as well.

Key points

A US citizen or resident alien living abroad is taxed on worldwide income, so foreign earnings belong on the US return whether or not any US tax ends up due.
The foreign earned income exclusion requires foreign earned income, a tax home in a foreign country, and either physical presence in a foreign country for at least 330 full days in 12 consecutive months, or bona fide residence in a foreign country for an uninterrupted period covering an entire tax year — the bona fide residence route being open to US citizens, and to resident aliens only where they are a citizen or national of a country with which the United States has an income tax treaty in effect.
The foreign earned income exclusion is claimed on Form 2555, is capped at an amount adjusted annually for inflation, and cannot exceed the foreign earned income for the year.
The foreign earned income exclusion reduces regular income tax on foreign self-employment earnings but does not reduce self-employment tax.
Tax on income remaining after the foreign earned income exclusion is figured at the rates that would have applied without the exclusion, using the Foreign Earned Income Tax Worksheet in the Form 1040 instructions.

What income does the United States tax?

A US citizen or resident alien who lives abroad is taxed on worldwide income. Income earned in another country is not outside the US return because it was earned elsewhere, and the same is true of income paid into a foreign bank account or a foreign company. The relief that exists is specific, conditional, and claimed on a form.

That is why the reporting side travels with the tax side. Someone earning abroad usually has foreign accounts, and those accounts can carry their own annual reports that are separate from the income tax return and filed in a different place.

Who qualifies for the foreign earned income exclusion?

Three conditions have to line up under section 911. You must have foreign earned income, your tax home must be in a foreign country, and you must be one of the following: a US citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year; a US resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country for an uninterrupted period covering an entire tax year; or a US citizen or resident alien physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

The tax home condition is where claims most often fail. You may have a foreign tax home if your work is in a foreign country and you expect to be employed there for an indefinite rather than a temporary period. You do not have one if your abode remains in the United States, meaning the place where you keep closer familial, economic, and personal ties, unless you are working in a Presidentially-declared combat zone in support of the Armed Forces.

What counts as foreign earned income?

Foreign earned income means wages, salaries, professional fees, or other amounts paid to you for personal services you rendered. It does not include amounts received for services provided to a corporation that represent a distribution of earnings and profits rather than reasonable compensation — a live issue for an owner who pays themselves from their own company while living abroad, and a reason the salary-versus-distribution split needs deliberate attention.

Several categories are outside the definition entirely: pay as a military or civilian employee of the US government or its agencies, pay for services performed in international waters or airspace, payments received after the end of the tax year following the year the services were performed, pay that is otherwise excludable such as employer-provided meals and lodging, and pension or annuity payments including social security benefits. A foreign housing exclusion or deduction can apply alongside the earned income exclusion, and a self-employed person may be eligible for the housing deduction rather than the exclusion.

What does the exclusion not do?

It is capped. The excludable amount adjusts annually for inflation, and Form 2555 will not let you exclude or deduct more than your foreign earned income for the year. Anything above the cap stays on the return.

It does not reduce self-employment tax. A qualifying individual can claim the exclusion on foreign earned self-employment income, but the excluded amount reduces regular income tax only, so an owner running a business abroad can still owe the Social Security and Medicare component. And it does not lower your rate: tax on the income that remains after the exclusion is figured using the rates that would have applied had you not claimed it, through the Foreign Earned Income Tax Worksheet in the Form 1040 instructions.

Where foreign tax was actually paid, the foreign tax credit is the other route, but the two do not apply to the same dollars. Foreign tax paid on income excluded under the foreign earned income exclusion cannot be credited, and claiming a credit on excluded income may be treated as revoking the exclusion. Foreign tax on the income that remains taxable, including earnings above the cap, can still be credited, and which relief leaves a household better off is a calculation to run rather than an assumption to make.