When you take the foreign earned income exclusion, your tax is not just calculated on the income amount on Form 1040. 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. Therefore, when the amount of excluded foreign income increases, some of the other income gets pushed into a higher tax bracket, and is taxed at a higher percentage. That's why your tax increases even though the taxable income is the same.
To perform this stacking of income the tax calculation has to be done on the Foreign Earned Income Tax Worksheet. In TurboTax Online the only way to see the worksheet is to print your entire tax return with the government and TurboTax worksheets included.
Basically the calculation is three steps.
- 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.
- Calculate what the tax would be on the excluded amount only, if that were your only income.
- Subtract the result of step 2 from the result of step 1.
