Taxes and form 2555 Excluding foreign earned income

[S & J 0]

Hey All,

Just wanted to clarify some info as prior posts relating to taxes always refer to using form 2555. As I was contemplating going back and amending my husbands (the USC) income tax returns to married filing jointly and then excluding my Candian income using this form I found out that in 2006 the legislation changed and it is no longer so black and white.

They have changed it so that even though the foreign income will be excluded the income that is to be taxed (eg. my husband's US income) is now taxed at a higher rate - and from what I have read it starts at 25% (previously 10%). Needless to say the couple of hundred I expected to get in a refund had I filed actually would have had us owing.

So for all of you who are like me and have foreign income - it looks like the new favorite choice would be including all of your foreign income in the T1040 and using Form 1116 for the Foreign tax credit.

Obviously, this isn't meant to replace any tax accountants advice, but I wanted to put the warning out there - if you have a tax program run the numbers using the different scenarios instead of soley using Form 2555.

[trailmix 77]

So just to clarify - if I use form 2555 to exclude the income, the USC will be taxed at a higher rate?

This is confusing!

[S & J 0]

So just to clarify - if I use form 2555 to exclude the income, the USC will be taxed at a higher rate?

This is confusing!

Not is there isn't a lot of income. For 2008 the married filing jointly tax rate doesn't jump from 15% to 25% until $65,100. That is why you want to play with all scenarios available to you and take the one that offers the least amount of tax payable. Which, if you pay a lot of tax to Canada, may be Form 1116.

[Caladan 19]

Definitely run it through a program; the income exclusion is sometimes better, but it's not a straight "we don't count this income". Income that isn't excluded will be partially taxed at a higher marginal rate. (This makes sense, if you think about it: if you made 80,000 overseas, and 10,000 here, it wouldn't make sense to treat you as if you only made below poverty level wages.) There's a formula for it in the 1040.

[trailmix 77]

Definitely run it through a program; the income exclusion is sometimes better, but it's not a straight "we don't count this income". Income that isn't excluded will be partially taxed at a higher marginal rate. (This makes sense, if you think about it: if you made 80,000 overseas, and 10,000 here, it wouldn't make sense to treat you as if you only made below poverty level wages.) There's a formula for it in the 1040.

ahhh I see. Yeah I never really looked in to the different scenarios as I never had any U.S. income when I filed for 04, 05, 06. Interestinggggg.

Well not really, it's taxes

Edited January 13, 2009 by trailmix

[zyggy 9]

Hey All,

Just wanted to clarify some info as prior posts relating to taxes always refer to using form 2555. As I was contemplating going back and amending my husbands (the USC) income tax returns to married filing jointly and then excluding my Candian income using this form I found out that in 2006 the legislation changed and it is no longer so black and white.

They have changed it so that even though the foreign income will be excluded the income that is to be taxed (eg. my husband's US income) is now taxed at a higher rate - and from what I have read it starts at 25% (previously 10%). Needless to say the couple of hundred I expected to get in a refund had I filed actually would have had us owing.

So for all of you who are like me and have foreign income - it looks like the new favorite choice would be including all of your foreign income in the T1040 and using Form 1116 for the Foreign tax credit.

Obviously, this isn't meant to replace any tax accountants advice, but I wanted to put the warning out there - if you have a tax program run the numbers using the different scenarios instead of soley using Form 2555.

Using Form 2555, you have to look at the entire picture and understand how it works.

1) When you use Form 2555, one needs to understand that the way taxes are calculated is a little different. Most people expect that you pay the amount on the AGI after the foreign income has been excluded. THis is not the case. The tax you owe is calculated as follows:

a) tax is calculated on taxable income with the foreign income

B) tax is calculated on foreign income amount

the tax that is owed is a-b

If one is filing MFJ, and the foreign income is such that income a is in one tax bracket and income b is in amother tax bracket, you could end up paying a larger percentage of tax that one would expect on just the USC income alone as MFJ.

2) You can declare the income and use form 1116 and take a foreign tax credit on the foreign income amount. This could result in a lower federal tax, however, if you live in a high state tax state, you could take a big hit in state taxes since your AGI would be higher than with option 1.

The lesson is that you have to do your taxes several ways and see which method leaves you with the lowest overall tax burden. There is no one clean cut way to do it.

And doing either option 1 or 2 is almost always more beneficial than doing your taxes as MFS.

Edited January 14, 2009 by zyggy

[sly_wolf 199]

Do the options that one takes also depend on whether you are a resident alien versus a non-resident alien?

I was under the impression that if someone is considered a resident alien you can only take the foreign tax credit and not the foriegn earned income credit.

Sly

[Texanadian 10]

Hmmmm, if we added our income, it would have meant the 25% bracket. But we were married-joint and in the 15% bracket using the 2555-EZ (excluding Cdn income)

The wording of the 1040 is a bit confusing. Because if you look only at the 1040, it says add up the lines from 7-21 and line 22 is your total income......The 2555-EZ says to put in your foreign income on line 21 of the 1040, which would make it seem like it's being added to your total on line 22. But you actually subtract it rather than add it. So in reality, it is being added to your 1040 and then it's being subtracted to your 1040.

The net result being the 1040 only taxes the US spouse's income.

The AGI is on line 37 which comes later on. The 2555-EZ amount (assuming you made less than $85,700 foreign income or whatever the limit is for your tax year) is invisible to the AGI.

(I filed as resident alien for the entire year. Also meant I was eligible for the full stimulus package that got mailed out last year. Non resident aliens wouldn't have qualified)

Edited January 15, 2009 by Texanadian

[zyggy 9]

Hmmmm, if we added our income, it would have meant the 25% bracket. But we were married-joint and in the 15% bracket using the 2555-EZ (excluding Cdn income)

The wording of the 1040 is a bit confusing. Because if you look only at the 1040, it says add up the lines from 7-21 and line 22 is your total income......The 2555-EZ says to put in your foreign income on line 21 of the 1040, which would make it seem like it's being added to your total on line 22. But you actually subtract it rather than add it. So in reality, it is being added to your 1040 and then it's being subtracted to your 1040.

The net result being the 1040 only taxes the US spouse's income.

The AGI is on line 37 which comes later on. The 2555-EZ amount (assuming you made less than $85,700 foreign income or whatever the limit is for your tax year) is invisible to the AGI.

(I filed as resident alien for the entire year. Also meant I was eligible for the full stimulus package that got mailed out last year. Non resident aliens wouldn't have qualified)

That's how your AGI is calculated but it is NOT how your taxes are calculated. THe way the taxes are calculated is they take the Tax calculated on the 25% bracket and subtract it from the taxes calculaed on the amount of Foreign income (probably 15% tax bracket). It subtracts the former from the latter. So the tax will be higher in this case than if it was calculated on the USC income alone. Especially if both incomkes together push you into a higher tax bracket.

Edited January 16, 2009 by zyggy

[Texanadian 10]

Can you show me where or how this works? Because when I did the 2007 return, there was no mention anywhere of being in a 25% tax bracket during calculations.

Edited January 16, 2009 by Texanadian

[zyggy 9]

Can you show me where or how this works? Because when I did the 2007 return, there was no mention anywhere of being in a 25% tax bracket during calculations.

See the Foreign Earned Income Tax Worksheet- Page 37 in the instructions to Form 1040.

Edited January 17, 2009 by zyggy

[kelvin_omar25 0]

I am so confused!!!

I hate taxes..........

Ok... I have a question... My wife is Colombian and I am the USC. My wife has NEVER been to USA. I live in FL and never lived in Colombia....I know that I have to fill a W-7 to obtain her ITIN, since this is the first time I file taxes as married filing jointly. Ok... Do I have to put her income on the 1040... By reading this forum I think so... I would have to add it to my wages on line 7 and then subtract it on line 21.... right? her salary is very little.... its aprox. $4,500... Another question... When filling out the form 2555ez... what should I mark on questions 1, 2 and 3... I sincerely do not know if these questions should be answered by me or by my wife.......

PLEASE HELP!!!!

Thanks in advance.. and sorry for my confusion....

Kelvin

[Texanadian 10]

Can you show me where or how this works? Because when I did the 2007 return, there was no mention anywhere of being in a 25% tax bracket during calculations.

See the Foreign Earned Income Tax Worksheet- Page 37 in the instructions to Form 1040.

Well this is a rather interesting one. We both seem to be right.

Your explanation of looking at the 1040 instructions page 37 does show the foreign income exclusion to be a+b incomes = tax1.......b income = tax2........tax1 - tax2 = final result. It doesn't necessarily mean the 25% bracket will be used for calculating the a+b taxation. Since line 43 is the taxable income after deducting the standard deduction and dependents.

On the other hand, using my answer of using the 2555-EZ instructions and the 2555-EZ paperwork, it shows you add the foreign income on line 7 of the 1040 (wages, taxable income etc) and then after filling out the 2555-EZ, you subtract the foreign income exclusion on line 21 of the 1040 to get the "total income" on line 22

So to put some numbers in, if the US person made 50K and the foreign person made 30K. It would be

line 7 = 50K + 30K

line 21 = (2555-EZ) 30K

line 22 = 50K

At which point you'd then go take the standard deduction and dependents and in effect, the foreign income is invisible.

Now maybe they never bothered to update the instructions for the 2555-EZ and/or the 2555-EZ form. But it could be that the 1040 instructions are wrong too. It's a coin toss. Both are explicitly clear, but contradictory.

[Caladan 19]

Last year we used TurboTax, but when I noticed that the AGI and the tax projected by the tax tables didn't line up, I calculated it by hand by looking up the tables in the 1040.

Essentially, if you're excluding foreign income, you don't use the usual tables, you use the tables on page 37 first, which calculate a different number that taxes some of your income at a higher rate (if you've jumped tax brackets.) In our case the difference was almost $700, because C. had earned $20K in Canada.

The numbers *are* different, and TurboTax uses the number that uses the secondary table on page 37. Foreign income is *not* straightforwardly invisible.

Last year we used TurboTax, but when I noticed that the AGI and the tax projected by the tax tables didn't line up, I calculated it by hand by looking up the tables in the 1040.

Essentially, if you're excluding foreign income, you don't use the usual tables, you use the tables on page 37 first, which calculate a different number that taxes some of your income at a higher rate (if you've jumped tax brackets.) In our case the difference was almost $700, because C. had earned $20K in Canada.

The numbers *are* different, and TurboTax uses the number that uses the secondary table on page 37. Foreign income is *not* straightforwardly invisible.

[Trompe le Monde 1,107]

This actually is interesting! (well, to me)

I had always thought that it was a matter of excluding the foreign income, which is what I did the last time I filed on UK income which was in 2005. However, my state taxes are being audited for that year with the state of California saying that they have progressive tax and my worldwide income would be considered to do this. I was kind of fine with that, until I did some calculations and found that I had already paid more in tax in 2005 to the UK government, federal government and California than I would had I been a resident of California the entire year, and with the additional money they want (which I have not yet paid) my total tax bill would be about $2k more than if I had been resident for all of 2005.

I did my taxes myself, so have possibly screwed it all up.

Also, when I read the instructions for the 2555 I don't see any guidance for currency exchange - unless I am blind and have completely missed it. When I filed my taxes I asssumed I wasn't liable for any of my UK income so merely translated the total amount in pounds to dollars using the rate of exchange that day which was £1=$1.97. However, when I was actually present in the UK the rate was more like £1=$1.71 so it hardly seems like a fair to use that rate.

Does anyone know what I should do? (hire an accountant, obviously)