When I enter foreign income in "Foreign Earned Income" it increases Fed/State taxes due. Then, I pass the exclusion test, but the due amounts do not change. Why?

[rjs · Accepted solution]

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.

[mnrosinger]

Is this answer correct? If so, is it still true for the 2018 tax year? If it is, then it is a terrible testimony of how the government deceives the general public. How can the income be "excluded" when it is "included" in the taxable income amount pushing you into a higher tax bracket?

[rjs]

@mnrosinger  The answer is correct. It is still true for 2018. The new tax law has not changed this calculation. If you carefully examine the answer above and the tax calculation on the Foreign Earned Income Tax Worksheet you will see that, while the foreign earned income does increase the tax on your non-excluded income, the foreign income is not really included in your taxable income. I agree that this is something of a fine distinction, but it's what the tax law requires.

If you wish, as an experiment, since you are using the CD/Download TurboTax software, you could make a copy of your tax return with a different name and change it to not claim the foreign earned income exclusion. Then you will see that the tax is much higher, so you will see how much you benefit from the exclusion, even though it's not quite the same as if the foreign income was completely ignored.

[benchew]

That is what happen to me too... and i was searching high low why my tax was so after even FEIE is applied. I was so afraid that TTax was wrong that i went to HRBlock and in the end... came back to the same calculation!