U.S. citizens and resident aliens living abroad often face double taxation—paying tax both in the U.S. and in a foreign country. Fortunately, the U.S. tax system offers two powerful tools to help reduce this burden: the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE). But which one should you choose for the 2025 tax year?
This guide compares both options side by side, helping expats, dual residents, and globally mobile professionals decide how to optimize their foreign income tax situation.
🌍 Overview of Foreign Income Tax Rules
U.S. taxpayers are taxed on their worldwide income, regardless of residency. If you live abroad and earn income in another country, you may:
- Claim a Foreign Earned Income Exclusion (up to $130,000 for 2025, indexed for inflation)
- Or take a Foreign Tax Credit for taxes paid to a foreign government
- Or, in some cases, combine both for different types of income
💼 What Is the Foreign Earned Income Exclusion (FEIE)?
Using Form 2555, qualifying taxpayers can exclude a portion of their earned income from U.S. taxation if they:
- Have a tax home in a foreign country
- Meet either the Physical Presence Test (330 days abroad in 12 months) or Bona Fide Residence Test
For 2025, the FEIE limit is $130,000 per person. You may also exclude certain housing costs under the Foreign Housing Exclusion.
🌐 What Is the Foreign Tax Credit (FTC)?
Using Form 1116, you can claim a dollar-for-dollar tax credit for foreign income taxes paid—reducing your U.S. tax bill directly.
Qualifying taxes must be:
- Legally owed and paid
- On income that is also taxed in the U.S.
- Income, war profits, or excess profits taxes
The FTC is non-refundable but can be carried back 1 year and forward 10 years.
📊 Foreign Tax Credit vs. Exclusion: Key Differences
| Criteria | Foreign Tax Credit (Form 1116) | Foreign Earned Income Exclusion (Form 2555) |
|---|---|---|
| Applies To | All foreign income with foreign tax paid | Earned income (wages, self-employment only) |
| Maximum Benefit | No cap (limited to U.S. tax liability) | $130,000/person in 2025 |
| Refundable? | No (but carryover allowed) | No |
| Housing Benefit | No | Yes, additional exclusion for housing expenses |
| Eligibility Requirement | Must have paid or accrued foreign taxes | Must pass residency or physical presence test |
| Best For | High-tax countries | Low or no-tax countries (e.g., UAE, Bermuda) |
📌 When Should You Use the FEIE?
Use the Foreign Earned Income Exclusion if:
- You live in a country with low or no income taxes
- Your foreign earned income is below $130,000
- You meet the physical presence or bona fide residence test
- You want to reduce your adjusted gross income (AGI) for other tax purposes
📌 When Should You Use the Foreign Tax Credit?
Use the Foreign Tax Credit if:
- You live in a high-tax country and pay significant foreign income tax
- Your income exceeds the FEIE threshold
- You want to claim credit on investment or passive income (not eligible for FEIE)
- You prefer not to exclude income from Social Security or IRA contribution calculations
⚠️ Common Mistakes to Avoid
- Claiming both FEIE and FTC on the same income (not allowed)
- Failing to file Form 2555 or Form 1116 with your tax return
- Using FEIE in years where residency or presence tests are not met
- Not reporting foreign income at all—this risks IRS penalties and FBAR violations
🤝 Can You Use Both?
Yes—with limits. You can use the FEIE for earned income and the FTC for other types of foreign income (like dividends or interest). However, you cannot claim both benefits on the same dollar of income.
✅ Final Thoughts
For 2025, choosing between the Foreign Tax Credit and Foreign Earned Income Exclusion depends on your income type, location, tax rates, and residency status. In high-tax countries, the FTC often yields better results. In low-tax countries, the FEIE may save more. Consider modeling both scenarios—or working with a tax advisor who specializes in expat taxes—to determine the most advantageous strategy.
Pro Tip: Once you elect the FEIE, you must continue to use it in future years unless you formally revoke it, which limits your ability to re-elect it for 5 years.
