Maximizing your tax savings with Foreign Tax Credit

Jameson Rader -

Welcome to our definitive guide on the Foreign Tax Credit (FTC) - an indispensable financial tool for U.S. expats and digital nomads traversing the globe.

In the confusing maze of global taxation rules, the FTC stands out as a beacon of relief, enabling American wanderers to offset their overseas income taxes against U.S. tax liabilities. 

This guide demystifies the FTC, laying bare its nuances, eligibility, and application processes, making your global adventures economically feasible and tax-efficient.

What is the Foreign Tax Credit (FTC)?

The Foreign Tax Credit is a financial cornerstone for U.S. citizens and resident aliens earning income beyond American shores. This tax provision is a strategic shield against the peril of double taxation — where both the U.S. and a foreign country claim the same income. 

The FTC empowers these international taxpayers to offset the taxes they pay abroad against their U.S. tax liabilities. Particularly advantageous in countries with higher tax rates than the U.S., it can substantially reduce, or sometimes entirely remove, the U.S. tax burden.

Purpose and benefits of the FTC

Combating double taxation: Since the US is the only country that taxes based on citizenship, regardless of where you live, the FTC's primary role is to prevent income double taxation. This is critical for the financial well-being of U.S. expatriates and digital nomads, safeguarding them from the financial strain of dual tax liabilities.

Opening doors globally: The FTC allows Americans to explore and embrace work opportunities worldwide. By easing the tax load, it encourages global mobility and professional growth.

Streamlining tax compliance: For U.S. citizens living overseas, the FTC simplifies the intricate web of tax compliance. It offers a straightforward route to fulfilling U.S. tax responsibilities while recognizing their international earnings.

Eligibility criteria for the Foreign Tax Credit

To qualify for the FTC, U.S. expats and nomads must meet certain conditions that affirm their tax obligations to foreign governments and ensure compliance with U.S. tax law. Here's a rundown of the criteria:

Mandatory tax imposition

First, the tax abroad must be a mandatory charge by a foreign government or U.S. possession, either paid or accrued by the taxpayer. This criterion separates obligatory payments from voluntary ones.

Nature of the tax

The tax in question must be an income tax or its equivalent. This excludes indirect taxes like VAT or sales tax, except when they substitute for an income tax.

The tax must represent a real liability, legally due without the possibility of a significant refund or rebate, ensuring the legitimacy of the tax claim.

Source of income

The focus is on income earned outside the U.S. That is, for the income to qualify, the taxpayer must have earned it outside the US. 

Limitation of the FTC

The FTC has only extended so far with a cap that can change annually. As of 2024, the limit is $126,500 (up from $120,000 from 2023). The credit no longer protects any foreign-earned income above this threshold. 

Specific exclusions

Certain foreign taxes are excluded, such as those paid to sanctioned countries or on income exempt under other U.S. tax provisions (like the Foreign Earned Income Exclusion).

7 Steps to Claim Foreign Tax Credit

Claiming the Foreign Tax Credit requires a clear understanding of the steps and rules.

The steps are as follows:

Step 1: Confirm Eligibility

First, ensure you meet the FTC eligibility criteria. Reference the previous chapter for details on that criteria. 

Step 2: Choose deduction or credit

You can opt for either a deduction or a credit. A deduction lowers the amount of income subject to taxation, while a credit reduces the final tax owed. Typically the credit is a more beneficial and straightforward way to reduce your U.S. tax.

Step 3: Filling out Form 1116

Electing the credit or deduction requires completing Form 1116. Attach this form to your tax return.

Step 4: Currency conversion

Convert foreign taxes to U.S. dollars using the appropriate exchange rate.

Step 5: Understanding limits

Of course, the credit can only be up to either the sum of US tax owed (sorry, the government won’t pay you if your credit exceeds taxes!) or the FTC limit for that year ($126,500 for 2024).

Step 6: Handling excess credits

Excess credits can be carried over or back to other tax years.

Step 7: Filing the return

Attach Form 1116 to your federal tax return, keeping an eye on deadlines and extensions, especially as these can sometimes vary for expats.

Foreign Tax Credit carryover and limitations

The Foreign Tax Credit (FTC) offers flexibility for U.S. expats with its carryover and carryback options.

Here's a closer look at how these work:

Carryover and carryback

  • Carryback: Excess credit can be applied to the immediate previous tax year, possibly necessitating an amendment to that year's return.
  • Carryforward: Remaining credits, after carryback or if you opt not to carry back, can be carried forward for up to 10 years. Post 10 years, any unused credits expire.

FTC limitations

  • The FTC applies only to foreign income that is also subjected to U.S. taxation.
  • The foreign tax must be a legal, actual liability that is not refundable or eligible for itemized deductions.
  • The credit's limit matches the U.S. tax owed on foreign-earned income, meaning it cannot generate a U.S. income tax refund.
  • It also cannot reduce the U.S. Net Investment Income Tax.

Calculating FTC and carryover

Calculating the FTC involves allocating foreign taxes paid to income categories and completing Form 1116 for each type. The credit per category may be limited based on the ratio of taxable foreign income to total taxable income. 

State tax implications

When delving into the Foreign Tax Credit (FTC) and its federal benefits, U.S. expats should not overlook state taxes. State tax laws often operate independently from federal rules, and understanding these can be pivotal in effective tax planning.

Understanding state residency

Residency Rules: Your obligation to pay state taxes largely hinges on your residency status. Each state has unique criteria for determining if you're considered a resident for tax purposes.

Domicile vs. Statutory Residence: States differentiate between domicile, your permanent home, and statutory residence, which can depend on the duration of your presence in the state.

Varied state approaches to the FTC

The FTC's application at the state level is not universal. Some states may offer a credit for foreign taxes paid, similar to the federal FTC, while others might allow deductions or not provide any relief at all. 

FTC recognition by States

States with Foreign Tax Credit provisions:

  • Arkansas
  • California (Only for Canada)
  • Connecticut (Only for Canada)
  • Hawaii
  • Indiana
  • Iowa
  • Kansas
  • Massachusetts (Only for Canada)
  • Michigan (Only for Canada)
  • Minnesota (Only for Canada)
  • New York (Only for Canada)
  • North Carolina
  • Vermont (Only for Canada)
  • Virginia

States with No Foreign Tax Credit:

  • Alabama
  • Colorado
  • Delaware
  • Georgia
  • Idaho
  • Illinois
  • Kentucky
  • Louisiana
  • Maine
  • Maryland
  • Mississippi
  • Missouri
  • Montana
  • Nebraska
  • New Jersey
  • New Mexico
  • Ohio
  • Oklahoma
  • Oregon
  • Pennsylvania
  • Rhode Island
  • South Carolina
  • Utah
  • West Virginia
  • Wisconsin

States with no State Income Tax (no FTC applicable):

  • Alaska
  • Florida
  • Nevada
  • *New Hampshire (No general state income tax on earned income)
  • South Dakota
  • Tennessee
  • Texas
  • Washington
  • Wyoming
State Income Tax Rates by States

Strategic residency changes for tax advantages

For those planning to move abroad, strategically altering state residency can result in considerable tax benefits.

Transitioning to a state with favorable tax laws for expatriates, such as those without state income tax (e.g., South Dakota, Florida, Texas, Nevada), can lead to significant savings. 

South Dakota vs Florida vs Texas vs Nevada vs Wyoming domicile

However, it's essential to consider ongoing connections to your former state, as maintaining ties (such as property or a physical presence) could affect your tax residency status and obligations.

Establishing non-residency in a tax-friendly state involves specific steps, such as obtaining a driver’s license, registering vehicles, and getting proper insurance in that state​​​​.

Examples of the Foreign Tax Credit in practice

Let’s take a look at how the FTC plays out for three American expats with differing circumstances:

Single digital nomad from California earning $85,000:

  • Foreign Earned Income: $85,000
  • Foreign Taxes Paid: $22,000
  • Federal Tax Bill Before FTC: $16,000
  • FTC Claimed: $16,000 (capped at the U.S. tax liability on foreign income)
  • Federal Tax Bill After FTC: $0
  • California State Tax: Assuming a rate of approximately 6%, the estimated state tax would be $5,100.
  • Total Savings on Federal Taxes: $16,000.

Expat couple from Virginia with a combined foreign income of $160,000:

  • Combined Foreign Earned Income: $160,000
  • Total Foreign Taxes Paid: $40,000
  • Combined Federal Tax Bill Before FTC: $32,000
  • FTC Claimed for Each: $32,000 (matched to U.S. tax liability on foreign income)
  • Combined Federal Tax Bill After FTC: $0
  • Virginia State Tax: With rates up to 5.75%, the estimated state tax would be approximately $9,200.
  • Total Savings on Federal Taxes: $32,000 

Remote IT specialist from Florida with an income of $95,000:

  • Foreign Earned Income: $95,000
  • Foreign Taxes Paid: $25,000
  • Federal Tax Bill Before FTC: $18,000
  • FTC Claimed: $18,000
  • Federal Tax Bill After FTC: $0
  • Florida State Tax: $0 (as Florida does not impose a state income tax)
  • Total Tax Savings: $18,000, with no additional state tax due.

In these scenarios, we observe how residency and the choice of home state can significantly affect the overall tax obligations of U.S. expats. While the FTC can provide relief at the federal level, state taxes may still be a concern depending on state laws and the individual's residency status. 

It’s important for expats from states like California, New York, and Virginia to plan accordingly, as they may still face state tax liabilities despite their international income.

Conversely, Florida residents, like residents from other states with no income tax, can benefit considerably, making their financial picture simpler while abroad.

FAQ

What is the difference between foreign-earned income and foreign tax credit?

The Foreign Earned Income Exclusion (FEIE) allows qualifying U.S. taxpayers to exclude a portion of any foreign income (up to $126,500 in 2024) from their taxable income. To qualify, one must meet residency or physical presence requirements in a foreign country.

The Foreign Tax Credit (FTC) provides a credit for taxes paid to other countries on foreign income, applicable to both earned and unearned income. It directly reduces U.S. tax liability on a dollar-for-dollar basis and can be carried over to other tax years.

Can you claim foreign tax credit and foreign earned income exclusion?

Yes, you can claim both the foreign tax credit and the foreign earned income exclusion, but not on the same income. If you have foreign income that exceeds the foreign earned income exclusion limit, you could claim the exclusion up to that limit and then claim the foreign tax credit on the excess. This strategy can help to mitigate double taxation of the income that goes over the exclusion threshold. 

However, you cannot use the foreign tax credit to reduce your U.S. tax on income that you have already excluded under the foreign earned income exclusion. It's important to calculate each tax benefit separately and then decide how to apply them without overlap to comply with U.S. tax regulations.

Do foreign tax credits expire?

Foreign tax credits can be carried forward for up to 10 years or carried back to the previous tax year. If not used within this period, they expire and cannot be applied to U.S. tax liability. 

Credits must be used in the current year before tapping into carryovers. It’s best to start with the oldest credits first, as they expire soonest. The carryover ensures that the benefits of the foreign taxes paid are not lost due to mismatches in foreign taxes and U.S. tax liability across different year

Are foreign tax credits non-refundable?

Foreign tax credits are non-refundable, which means they can only reduce your U.S. tax liability to zero. They cannot result in a tax refund or create an overpayment.