Foreign earned income exclusion not applied correctly

[ps123]

Hello,

my wive worked in the netherlands for more than 380 days and did not return to the US in between. She also payed taxes in the netherlands and there is a tax treaty in place. After filling out section

"Foreign Earned Income and Exclusion" Turbo tax confirms that she is subject to the foreign earned income exclusion. Her income is below 15000 dollar.

However, when I add her income in this section this increases the taxes we owe by roughly 2800 dollar. This seems a bug in Turbo tax to me as due to the foreign earned income exclusion no tax should be owed on this income as she already payed taxes in the Netherlands.

What am I missing?

Thanks a lot for your help!

[rjs]

It's not a bug in TurboTax. When you take the foreign earned income exclusion, the amount of excluded foreign income affects the amount of 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 you add the excluded foreign income, 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 when you add the excluded foreign income.

So you are not paying tax on your wife's foreign earned income, but having that income makes you pay a higher tax rate on your other income.

[ps123]

@rjsThank you! This is very helpful.

What confuses me is the size of the increase 2800$ in my tax coming from adding around 12k of non-taxable income. If this pushes some of our income from the 35% to the 37% percent bracket, this would be consistent with an increase of 2% *12000$, e.g. a tax increase of around 240$. The change in my taxes computed by turbo tax is an order of magnitude larger.

What am I missing?

Thanks again for being so helpful!

[rjs]

Here are a few things to check.

A maximum of $112,000 (for 2022) of foreign earned income can be excluded. If your wife made more than that, her remaining foreign income cannot be excluded and is taxable.

Make sure you did not make a mistake entering the amount of your wife's foreign income. The excluded amount is on Schedule 1 line 8d, as a negative number. Also look at Form 2555 to see if you spot any errors.

You can see how the tax is calculated on the Foreign Earned Income Tax Worksheet. If you are using the CD/Download TurboTax software you can look at this worksheet in forms mode. If you are using TurboTax online you can see the worksheet if you save a PDF of your tax return and select the option to include government and TurboTax worksheets. Or you can see the worksheet on page 35 of the IRS instructions for Form 1040 and work through it yourself.

[ps123]

I went throught the tax forms generated by Turbo Tax:

the income shows up on line 1h, 8d, and throughout form 2555. The amount on line 8d is positive, but then it is nevertheless subtracted on line 9 (eventhough the number on line 8d is positive).

I am completely lost what the problem here is.

Thanks a again for your help!

[rjs]

Did you look at the Foreign Earned Income Tax Worksheet to see the tax calculation?

[ps123]

@rjsyes, I went through the Foreign Earned Income Tax Worksheet and the amount coming out of it is (as far as I can tell correct) and equal to the total foreign income of my wive. It is also correctly transferred to line 8d.

[ps123]

What confuses me is that the amound on line 8d exactly matches the amount on 1h, but nevertheless my tax burden is significantly increased when the foreign earned amount changes.

[rjs]

I think you're looking at Form 2555, not the Foreign Earned Income Tax Worksheet. Schedule 1 line 8d comes from Form 2555 line 45. The Foreign Earned Income Tax Worksheet calculates the tax, not the amount of income. Line 6 of the Foreign Earned Income Tax Worksheet goes to Form 1040 line 16.

The PDF attached below shows what the Foreign Earned Income Tax Worksheet looks like in TurboTax. If you are having trouble finding the Foreign Earned Income Tax Worksheet, please say whether you are using TurboTax Online or the CD/Download TurboTax software.

[Industrialmaterial]

I am having the same issue for the last two years. While my wife’s foreign income qualifies for exclusion, including it in our calculations increases our tax liability significantly. I have spent 2 hours with TT experts and they cannot explain why the software does that. I’m trying to get a call with a CPA to explain. Beyond the mechanics of the software. Can someone explain WHY excluded income does this? There’s no way that excluded income “layered” onto mine would add tens of thousands of addition tax. Or?

[rjs]

@Industrialmaterial  

Read the earlier replies in this thread, above yours, especially my first reply at the beginning of the thread. It explains the mechanics of the tax calculation and why the foreign earned income exclusion increases your tax.

Note that the excluded income is not "layered" onto your income. It's the other way around. Your income is "layered" (stacked) onto the excluded income. That's why your tax increases so much.

For 2024 the maximum amount of foreign earned income that can be excluded is $126,500. Any foreign earned income above that amount is taxable.

[Industrialmaterial]

Thank you. Yes I did read them prior to posting the question. So assuming all that is accurate- what still isn’t clicking for me is:

1. Her Foreign earned income is below the threshold.

2. The sum of our incomes doesn’t put us into another “bracket”. I.e. we are still taxed at the same percentage. So why does the tax burden on the taxable amount (my W2 income only) increase so much?

[rjs]

Your income is not all in the same tax bracket. It is not all taxed at the same percentage. Here's an illustration. (You cannot actually calculate your tax this way.)

For 2024, if you are married filing jointly, the first $23,200 of your joint taxable income is taxed at 10%. The next $71,100 of taxable income is taxed at 12%. The next $106,750 is taxed at 22%, and so on.

What happens when you claim the foreign earned income exclusion is that the excluded income fills up the lower-percentage brackets, although you don't actually pay the tax on it. But the excluded income pushes your other income, that's not excluded, up into the higher-percentage brackets. That's what's meant by "stacking" the non-excluded income on top of the excluded income, and that's why the tax on your non-excluded W-2 income increases.

When people say "we're in the 22% bracket" or "we're in the 24% bracket" they are talking about the highest bracket that any of their income falls in - the rate that applies to the last dollar of their income. It doesn't mean that all of their income is taxed at 22% or 24%.

The percentage steps are uneven: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. If a portion of your income gets pushed up from 22% to 24% the additional 2% tax would not make a dramatic difference. But if a large amount of income gets pushed from 12% to 22% or from 24% to 32% the additional tax could be significant.

[Industrialmaterial]

Thanks for this great explanation. However, what is still a mystery. When I remove the income from the Foreign Earned Income position. And then reenter it as Hobby Income that has not yet been taxed (paid zero tax on it)-the tax burden increases by an identical amount. So at that point - wouldn’t it be accurate to read that as being taxed as income now? Because it would be being taxed as normal additional income as “other income” (not being excluded)?  The impact is more than the “layering” effect. 

[Industrialmaterial]

I should say “more than what I would expect from the layering effect”.