One of the most common misconceptions regarding US tax filing from New Zealand is the “$120,000 threshold”, otherwise known as the Foreign Earned Income Exclusion (FEIE).
In part due to poor clarity from the IRS, a large number of US citizens were incorrectly led to believe that there is a $120,000 threshold for filing US taxes, when living overseas.
But, what actually is the Foreign Earned Income Exclusion, and is there actually a $120,000 threshold?
Foreign Earned Income Exclusion (FEIE)
Firstly, unfortunately no, there is no $120,000 filing threshold. Rather, there is indeed a $120,000 exclusion from taxable income for US filers living abroad, however this is an exclusion, not a filing threshold. In order to claim the exclusion, a tax return must be filed.
The Foreign Earned Income Exclusion allows qualifying U.S. citizens or resident aliens who live and work abroad to exclude a certain amount of their foreign-earned income from U.S. taxation.
For tax year 2023, the maximum exclusion amount is $120,000 per qualifying individual. This means that if your foreign income falls within this threshold, you may not owe any U.S. federal income tax on it, but a tax return must still be filed.
To qualify for the FEIE, individuals must meet either the bona fide residence test or the physical presence test. The bona fide residence test requires individuals to be bona fide residents of a foreign country for an uninterrupted period that includes an entire tax year. The physical presence test mandates individuals to be physically present in a foreign country for at least 330 full days during any consecutive 12-month period.
One significant advantage of the FEIE is its simplicity. Once eligible, individuals can exclude their foreign-earned income by filing Form 2555 along with their tax return.
It is important to keep in mind however, that KiwiSaver trust reporting, or other passive income, is not excluded using Form 2555. For US citizens overseas with any passive income or a New Zealand retirement account, professional help should still be sought with return preparation.
Foreign Tax Credits (FTC)
The more common method used to prevent a US tax liability for US citizens living overseas, is to use the Foreign Tax Credit method.
Rather than excluding income from taxation, the FTC allows taxpayers to offset taxes paid to a foreign government against their U.S. tax liability. This means that if you've already paid taxes to New Zealand on income that is also subject to U.S. taxation, you can use the FTC to prevent double taxation.
Foreign tax credits are claimed using Form 1116, which calculates the amount of credit which can be claimed based on the foreign taxes paid. However, there are limitations to the FTC. The credit cannot exceed the amount of U.S. tax attributable to the foreign income, and certain types of income may not qualify for the credit.
Choosing Between FEIE and FTC
Deciding between the FEIE and FTC depends on various factors such as income level, foreign tax rates, and individual circumstances. Generally, the FEIE is more beneficial for individuals with lower incomes that fall within the exclusion limit. It simplifies tax filing and can lead to a significant reduction or elimination of U.S. tax liability.
On the other hand, given that New Zealand generally has higher income tax rates than the US, FTC is usually preferable, as unused FTC can be carried forward to future years.
The main benefit is that we can use FTC to offset US tax on almost all types of income, as opposed to the FEIE which is limited only to earned income. It allows taxpayers to offset foreign taxes paid against U.S. taxes owed, reducing the risk of double taxation and potentially resulting in a lower overall tax liability.
Conclusion
Understanding the differences between the Foreign Earned Income Exclusion and Foreign Tax Credits is essential for Americans living and working in New Zealand. While both mechanisms aim to alleviate the tax burden on expatriates, they operate differently and cater to distinct financial situations.
When working with The US Tax Team New Zealand, we make a determination of the most beneficial route to use, ensuring professional judgement is taken into account.
If you have any questions on FEIE vs FTC, or are seeking US tax advice, reach out to us at info@usatax.nz or 09-242-2445