@DMari wrote:
In other words, 1040 line 10 shows 100,000 but tax is calulated on 120000 and then the tax amount is reduced by tax on 20000!
Yes, that is exactly how the tax is calculated. When you take the foreign earned income exclusion, your tax is not just calculated on the taxable income amount on Form 1040 line 10. 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 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, the excluded foreign income pushes some of the other income into a higher tax bracket, so it is taxed at a higher percentage.
To perform this stacking of income the tax calculation has to be done on the Foreign Earned Income Tax Worksheet. You can look at this worksheet in forms mode in TurboTax, or on page 39 of the IRS instructions for Form 1040. Basically the calculation is three steps, as you have observed.
- 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. (Income on worksheet lines 1 - 3, tax on line 4)
- Calculate what the tax would be on the excluded amount only, if that were your only income. (Worksheet line 5)
- Subtract the result of step 2 from the result of step 1. (Worksheet line 6)
