Moving abroad to start a new job can be one of the most exciting yet stressful experiences of your life -- but it can also end up saving you a bundle in federal income tax. This is because U.S. expatriates frequently take advantage of the foreign earned income exclusion to legally shield approximately $100,000 of income from the Internal Revenue Service's reach. Living and working abroad is naturally a requirement to take the exclusion, but it isn't the only one. Expats also need to satisfy certain tests and file additional forms to claim the tax benefit.
How the foreign earned income exclusion works
Because the Internal Revenue Code imposes tax on all income, regardless of whether you earn it in the U.S. or abroad, you're still responsible for filing annual tax returns while in the foreign country. But if you have "foreign earned income" and can satisfy two other requirements related to your tax home (i.e., your regular place of business) and residency abroad, you can avoid paying U.S. income tax on a substantial portion of the employment wages you earn by claiming the foreign earned income exclusion. The maximum foreign earned income exclusion you can take is indexed for inflation -- which means the amount increases slightly each tax year. In the 2014 tax year, for example, you can exclude up to $99,200 of your foreign employment earnings from your taxes.
And one of the best aspects of the exclusion is that it's in addition to the exemptions and deductions you normally take.
You must be physically present or a bona fide resident
You have to satisfy either the bona fide residence or the physical presence test each year you plan on taking the exclusion. To be considered a bona fide resident, you have to live outside the U.S. for an uninterrupted period that covers a full tax year, which for most people is the calendar year. Under this test, the key factor is your intention to live in the foreign country indefinitely -- not permanently. For example, if you take a job in Germany and you intend to stay there for as long as you remain employed, you may be considered a bona fide resident. If, however, you're offered an 18-month employment contract and plan to return to the U.S. afterward, the temporary nature of your contract prevents you from being a bona fide resident. But you can take the foreign exclusion by satisfying the physical presence test instead. The physical presence test doesn't focus on your intent to reside in Germany or any other foreign country; rather, you just have to be outside of the U.S. for at least 330 days of any consecutive 12-month period.
Your tax home
The tax law only permits you to take the exclusions if you also have a foreign tax home. Your tax home is generally the area of your foreign employment, regardless of whether you still maintain a residence in the U.S. and intend to return there once your foreign employment ends.
Only foreign earned income counts
As the name implies, these exclusions only cover your income that's earned abroad. Income is "foreign-earned" if it's received as compensation (such as wages and salaries) for services you perform. In other words, you can't exclude foreign or domestic investment earnings, alimony payments, pension income, or other retirement benefits you receive.
Form 2555 and 1040 reporting
One important caveat of the foreign earned income exclusion is that it isn't automatic; you have to file a return on Form 1040 and report all foreign earnings on it before you can take advantage of it. You figure out how much your exclusion is by preparing Form 2555, or its abbreviated version, Form 2555-EZ. The exclusion is ultimately reported as a single negative number on the "other income" line of your return to reduce your tax bill.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.