Definition of Exclusion

• An exclusion from federal income tax provides one of the highest levels of tax savings in comparison to deductions and tax credits. When you can exclude income, it essentially means that you can reduce your gross income before you even start calculating your income tax or claim any deductions. In contrast, your deductions only reduce your taxable income after finalizing your gross income amount. Tax credits are more valuable than deductions since they reduce your tax bill on a dollar-for-dollar basis, but it is calculated after all exclusions and deductions once your tax liability is determined.
  
  

Foreign Earned Income

• The exclusion for American expatriates only applies to the income you earn abroad. Essentially, earned income refers only to the compensation you receive in exchange for services, most commonly when you work in a foreign country for a foreign employer. You still have to pay the full amount of income tax on unearned income including interest that accrues on both domestic and foreign bank accounts, any dividend payments you receive, royalties and everything else that does not require you to actively engage in some type of work activity.
  
  

Foreign Housing Exclusion

• Although not as large a benefit as the foreign earned income exclusion, you may also qualify to exclude from U.S. taxable income certain amounts that you pay out of your earned income for housing in the foreign country. Each year, the IRS determines what it calls the "base housing amount." Within limitations, you can exclude the amount by which your actual housing expenses in the foreign country exceed your base amount.
  
  

Tax Rates

• If your foreign income exceeds all of your exclusion amounts, you must pay income tax on the excess. However, one drawback is that the IRS will impose higher tax rates on this excess. Suppose you earn $125,000 this year, while living and working in Mexico, and your total exclusions equal $95,000. This means that you must pay tax on the $30,000 difference. However, the IRS imposes the rates that would have applied to this amount had your entire income been taxable. Essentially, you would calculate the tax on $125,000 and then again on $95,000. The difference between the two is what you owe. This is a much more expensive result than if you prepared your tax return reporting only $30,000 of gross income.