U.S. citizens and permanent residents must report their worldwide income to the Internal Revenue Service. However, the IRS offers many tax deductions for various expenses. Additionally, foreign-earned income is subject to special tax treatment, whether you earned the income while actually residing overseas or through investment in an overseas entity.
You may exempt an additional $3,700 from your taxable income for every dependent you support, including yourself. This exemption increases every year. In addition, you may claim certain "above the line" deductions on Page 1 of your Form 1040 tax return such as health savings account expenses, college tuition, moving expenses, alimony and student loan interest. If you itemize your deductions on Schedule A, you may deduct many more expenses including medical and dental expenses, charitable contributions, certain business expenses and theft losses. Itemizing your deductions on Schedule A is an alternative to claiming the standard deduction. As of 2012, the standard deduction ranged from $7,250 to $16, 200, depending on several factors such as your marital status.
Foreign Tax Credit
The foreign tax credit allows you to subtract taxes you paid to a foreign government from your U.S. tax liability. It applies even if you live the entire year in the United States -- if you pay foreign taxes incident to ownership of shares in a foreign corporation, for example. The foreign tax credit is an alternative -- if you use it, you cannot use either the foreign earned income exclusion and the foreign housing exclusion. A foreign tax deduction is another alternative, but the foreign tax credit usually saves you more money. If the U.S. tax rate is higher than the tax rate in the foreign country, you still have to pay the difference.
Foreign-Earned Income Exclusion
The foreign-earned income exclusion applies to taxpayers who reside abroad for a certain amount of time during the tax year, and earn income while residents there. As of 2012, you may exclude a maximum of $95,100 from taxable income earned while physically present overseas. If you lived abroad half the 2012 tax year, for example, your maximum exclusion would be $47,550. To claim the exclusion, you must meet either the bona fide residence test or the physical presence test. Although the rules for these tests are complex, they require you to live abroad for either most of the tax year or most of the previous tax year.
Some Americans have moved to countries with lower tax rates and renounced their U.S. citizenship to avoid paying U.S. income tax. The IRS, however, still imposes federal income tax on ex-citizens for 10 years after expatriation if the IRS determines that their renunciation of citizenship was for the primary purpose of avoiding U.S. taxes. This determination is based on complex rules and takes into account changes in the law over the years. If expatriation tax applies to you, you must comply with IRS reporting requirements or face tax penalties.
David Carnes has been a full-time writer since 1998 and has published two full-length novels. He spends much of his time in various Asian countries and is fluent in Mandarin Chinese. He earned a Juris Doctorate from the University of Kentucky College of Law.