Why does the refund amount go down when TurboTax Foreign Earned Income and Exclusion tab states "you will not pay U.S. tax on this amount"? (100% of it was excluded)

[forcecdr]

The Turbotax Facts:

Married Filing Jointly, - Wife is non-resident alien and qualifies (through the turbotax program screens) for 100% exclusion of her income.  We live and work in Japan.

My US Navy reserve income/W2 Info:
Wages:  33,318.00    Fed Income Tax:   3928.50
SS Wages:  33,318.00    SS Tax:  2065.72
Medicare wages:  33,318.00    Medicare Tax:  483.11

After entering only my wages (but showing us as married filing jointly) the estimated Refunds were:
Federal Refund:   $2,676.00    and  State (OR):   $978.00

The Federal Refund (my concern) is broken down by hovering the curser over the refund amount and showed: Income and Adjustments $33,318.  Deductions $12,700.  Taxable Income $12,518.  Total Tax $1,252.  Total Payments $3,929.  Refund/Tax Due $2677

As soon as I entering my wife’s income ($94,333) in the “Foreign Earned Income and Exclusions” section of the “Less Common Income” area, the estimated refunds changed to:
Federal Refund:   $798.00    and  State (OR):   $1,149.00

The Federal Refund now shows: Income and Adjustments $33,318.  Deductions $12,700.  Taxable Income $12,518.  Total Tax $3,132.  Total Payments $3,929.  Refund/Tax Due $797.

At the end of the process of determining the exclusion amount, Turbotax stated:

“Congratulations! XXXXXXX’s foreign earned income exclusion is $94,333.  You will not pay U.S. tax on this amount.”

But it did not change the refund amount back.  Why would our Total Tax changed based on something that we “will not pay U.S. tax on”?

[Zbucklyo · Accepted solution]

It is because while your wife's income is excluded for the purposes of determining your taxable income, it is not excluded for the purposes of determining the tax rate on your income.  In other words, based on your income alone, your tax rate is 10%. When your wife's income is included, your tax rate is 25%, which is the rate at which you'd be taxed with an additional $94,000 of income.

It is likely that this is one of the rare instances in which you'd be better off filing separately, because then the tax rate at which your income alone would be taxed is much lower, and since you wife is a non-resident alien she would owe no US tax anyway.

[forcecdr]

Right, that makes sense now.  Thank you.