Even though you do not pay tax on the excluded foreign income, it affects the amount of tax that you pay on your other income.
When you take the foreign earned income exclusion, your tax is not just calculated on the taxable income amount shown on your tax return. The amount of excluded foreign income affects the tax because your other income, that is not excluded, is taxed at the same rates that would have applied to that income if you did not get the exclusion. The non-excluded income is "stacked" on top of the excluded income for the purpose of calculating the tax. The tax calculation on the Foreign Earned Income Tax Worksheet performs this "stacking" of income. Basically the calculation is three steps.
1. Calculate what the tax would be if you did not have the exclusion. That is, add the excluded amount to your taxable income and calculate the tax on the total.
2. Calculate what the tax would be on the excluded amount only, if that were your only income.
3. Subtract the result of step 2 from the result of step 1.
Because the tax on the excluded income is subtracted in step 3, you are not paying tax on the excluded income. But the tax on the non-excluded income is higher than it would be if the non-excluded income were your only income, and you did not have any excluded income. That's because the stacking pushes some of the non-excluded income up into a higher bracket, so it is taxed at a higher percentage. You don't have to pay tax on the excluded income, but you don't get to pretend that you didn't have the additional income. You do pay more tax because your total income was higher, even though not all of the income is taxable.
When you enter the foreign earned income in TurboTax, it assumes that the income will be excluded. So when you "pass the exclusion test" nothing changes because TurboTax already treated the foreign income as excluded.
