Why does my spouse's foreign earned income that qualifies for exclusion increase our tax bill?

[lb1]

I work in the US but my spouse works for a foreign employer in a foreign country and her full income qualifies for foreign earned income exclusion. After I enter her income as foreign income and TT tells me that her full income qualifies for exclusion (also marked as such in form 2555), I see our total tax goes up significantly. Our MFJ return is otherwise pretty straightforward and we take the standard deduction if that matters. Why is my spouse's excluded income increasing our tax bill, almost by as much as if it's US-based income?

[TaxGuyBill · Accepted solution]

Just because it is "excluded" does not mean it is not taken into account for tax calculations.

When determining the tax bracket of the non-excluded income (such as your income), the tax bracket is based on the total income.  So effectively the excluded income 'uses up' the lower tax brackets and the non-excluded income stays in the higher tax brackets.

Also, the excluded income is still factored into many types of deductions and credits, so even though it is not directly taxed it may reduced (or eliminate) some deductions and credits.