U.S. taxpayers with foreign income face unique complexities, primarily due to the risk of double taxation. The two primary relief tools, the foreign earned income exclusion (FEIE) and the foreign tax credit (FTC), serve distinct purposes. Understanding how each operates under IRS guidance and code provisions is critical for practical client advice.

Understanding the mechanisms

Foreign earned income exclusion (FEIE)

The FEIE enables eligible taxpayers to exclude up to $130,000 of foreign-earned income in 2025, as increased by inflation adjustments from $126,500 in 2024. Qualifying requires meeting either the physical presence test (330 full days abroad in a 12-month period) or the bona fide residence test and establishing a foreign tax home. The exclusion applies only to earned income, such as wages or self-employment earnings, not to passive income, such as dividends, interest, capital gains or rental income. Importantly, FEIE does not reduce self-employment tax nor support eligibility for certain credits tied to earned income such as the additional child tax credit or earned income credit and excludes the income from IRA contribution calculations.

Foreign tax credit (FTC)

The FTC offers a nearly dollar-for-dollar offset against U.S. tax liability for foreign income taxes paid or accrued, up to the amount of U.S. tax on that same income. It applies to both earned and passive income and may generate carryback or carryforward opportunities for unused credits. However, the FTC process generally demands more rigorous recordkeeping and use of Form 1116, Foreign Tax Credit (Individual, Estate or Trust), a more complicated form.

Strategic decision-making

When FEIE is preferable

Clients residing in low-tax or tax-free jurisdictions may benefit most from the FEIE.

For example, Sarah, a U.S. citizen and freelance IT consultant, relocates to the United Arab Emirates (UAE) for a two-year contract. The UAE does not levy income tax on individual earnings. Sarah earns $110,000 in 2025 from her contract and is physically present in the UAE for 340 days of the tax year. She therefore qualifies for the physical presence test and files Form 2555, Foreign Earned Income (Form 1040),to report and then exclude her income. Her income is below the 2025 cap of $130,000, so her income of $110,000 is fully excluded from U.S. taxable income.

Note that since she paid no foreign income tax, the foreign tax credit is not applicable.

When FTC offers superior relief

The FTC generally delivers more comprehensive protection against double taxation for taxpayers living in high-tax countries. Since foreign tax rates often exceed U.S. rates, the FTC can diminish U.S. tax liability if the more complex rules are followed.

For example, Mark, a U.S. citizen and executive, lives and works in Germany, a country with high income tax rates. In 2025, he earns wages of $200,000 and pays €65,000 (approximately $70,000) in German income taxes. He is eligible for the foreign tax credit for three important reasons that seem overly simple, but which are important:

1. A tax was imposed on Mark that would have also been imposed in the U.S.
2. Mark paid the tax
3. An actual tax liability is established

Mark’s entire $200,000 is reported as income on his Form 1040, U.S. Individual Income Tax Return. He files Form 1116 and claims a foreign tax credit of $70,000 against his U.S. tax liability of about $46,000. Because his foreign taxes exceed his U.S. liability, he owes no U.S. income tax, and he carries forward the unused $24,000 credit for up to 10 years under §904(c).

Using both, with care

Taxpayers may occasionally leverage both FEIE and FTC within the same year, but never on the same portion of income. A common strategy is to apply FEIE to the first chunk of earned income (up to the exclusion limit), then claim FTC for foreign taxes paid on income above that limit or passive income. Practitioners must carefully allocate income and taxes to avoid IRS scrutiny.