Foreign earned income increases tax due even after exclusion!

[Taxsmith]

I am a US citizen living abroad.  Income items on my tax return are foreign earned income, capital gains, and income from K-1 statement. All the foreign income qualifies for exclusion under the rules.

I entered all my data into Turbo Tax except for the foreign earned income. Without foreign income, the tax liability was around 7K. Then I entered the foreign earned income (in the Less Common Situations section) and answered all the related questions. Adjusted gross income and taxable income remained the same as before (as they should), but the tax liability increased to 14K! I have gone through the forms in Forms mode several times but I cannot see why this is happening and it makes no sense. Any guidance is much appreciated.

[pk]

@Taxsmith , cannot answer the question with much confidence ( i.e. Turbo is computing tax in error or what  ), without more details  -- general figures of world income, foreign income, country of foreign income, when did you start your foreign stay -- tax home start date , are you still abroad  etc. etc.

However, even though the foreign income is  excluded , its effects still are  there in the computation of the  tax  ( the world income is without regard to excluded income, then the excluded  tax contribution is excluded ).

 I will circle back once I hear from you --yes ?

[Taxsmith]

@pk, as I mentioned, all of the foreign earned income qualifies for exclusion. I have been 100% abroad (Iceland) since 2019 and am still abroad. The foreign income is below the exclusion limit, so all of it can be excluded. Other income items are capital gains, interest, and K-1 business income (all US-source income). The K-1 business income is taxed in the US. The capital gains and interest income are taxed in Iceland (under the US-Iceland tax treaty, capital gains and interest income are re-sourced to Iceland, and Iceland has the first right to tax it).  Therefore, I take foreign tax credit on the US return for the tax paid to Iceland on capital gains and interest income. For the wage income earned in Iceland, I use the foreign earned income exclusion.

All the mechanics of the calculations are going through correctly as I checked in the forms mode. The foreign earned income, if all of it is excludable, does not (and should not) change the AGI and taxable income.  If AGI and taxable income do not change with the FEIE, then why does the tax liability double?

[pk · Accepted solution]

@Taxsmith , agreeing with your position that  excluded income should not  affect the  tax computation.  However the realities are different ---in the forms mode  select the tax computation worksheet and you will see that the calculation actually uses the world income without regard to exclusion to compute the tax and then from it subtracts  the taxes due to / allocated to excluded  Foreign income.   Personally I disagree with this allocation method  but it is blessed by the IRS and therefore  .....

Is there more I can do for you ?

[Taxsmith]

@pk,I found the tax computation in the Schedule D Tax Worksheet; is that the one you meant? That explains it, so thank you!  That entire calculation is so convoluted. The guiding principle of the IRS rules is - why simplify when you can complicate, confound, and confuse?

[DaveF1006]

The IRS never seems to wish to make things simple but that is what PK meant.

[taxguy69420]

Sorry to bring this back up, but what was the solution here? Was the software right or did you manually adjust something in the forms?  Facing the exact same situation as you where adding foreign income increases taxable amount even though it should all be excluded.

[pk]

@taxguy69420 , from your post I cannot  determine exactly why your taxes went up on  taking FEIE.   However, here are a few  areas  that may explain  :

Assuming that you had entered all the US income and saw your tax liability  ( federal )  and then  entered the  foreign earned income and used form, 2555 to exclude  all of it ( ?), 

(a) note that the  tax liability is computed  now  on world income ( i.e. including the excluded foreign income and then  the taxes  due to the excluded income is subtracted  --- the  computation that is used by TurboTax , IMHO, does put taxpayer at a slight dis-advantage though.

(b) unless you claim  relief from SECA ( at 15.3% of most of net wages/ active earnings ) is still computed  on Schedule-SE and included in the tax liability.

(c) there  may also be disqualification of some credits  based on world income, depending on exact circumstances and  facts.

If this does not explain your issue with TurboTax ( in your particular case ), please consider  providing some details of your situation.

Is there more I can do for you ?

I will circle back once I hear from you 

pk

[pk]

@Joseph56 , do you haver a question ?   Please provide some details and  I will circle back once I hear from you 

pk

[MWH2]

@pk Since as you say, the "computation that is used by TurboTax , IMHO, does put taxpayer at a slight dis-advantage though", will TurboTax do anything to correct this computation? It causes a significant change in the tax return even though this income is fully excluded. 

[pk]

@MWH2  the computation method, I believe is approved by the IRS , so I do not know if there is anything   to be done about it.  What  I am talking about  is that  while the excluded  income is added to the  rest of the world income , (thus pushing one to a higher marginal  bracket ),  the tax on the excluded amount is  computed as if that was the total amount -- thus  reducing the effect of the exclusion.   To my mind this puts the taxpayer at a disadvantage.  Unless taxpayers complain about  this , nothing will be done by the IRS and therefore by  the  tax prep. industry.     Sorry.

Is there more I can do for you ? 

pk

[matt_SG99]

A quick internet search shows that Turbo Tax is not recommended for those claiming foreign income exclusion.  I'm gonna try TaxAct.  Unfortunately, I already paid for Turbo Tax.  However,  the extra amount Turbo Tax would make me pay in taxes makes it worthwhile to use different software. 

[pk]

@matt_SG99 ,  I cannot  understand your dis-satisfaction with the TurboTax computation of tax liabilities  in cases with foreign earned income exclusion .   I have personally used TurboTax for foreign earned income exclusion ( but of course I did not go a check other services computation .  I agree there may be a small difference because rounding method and the use of tax table or computation---- but these are usually  in the range of a few dollars net.   I have been helping people in this arena for at least 18 years and have not seen this issue ( of course this does not mean that the issue does not exist).

I would feel privileged to work with your facts and see  where the issue is.   Would you help me by providing the details of your case ( no personally identifiable information please ) ?   Please .   And oif you feel that your situation is  unlikely to be of interest to the general population you can always  PM me .  Either way, once I get your details I will simulate and see why the  TurboTax is misbehaving.

Please will you help ?    Please note that I am not an employee   nor  have any financial ( or otherwise) benefit/connection to TubroTax / Intuit --- I just volunteer.

I will circle back once I hear from you 

pk

[taxguy69420]

Did TaxAct compute any differently?  As far as I can tell, TurboTax is computing this correctly but it's the tax rules themselves that are unfavorable. But I'd be glad to know if other programs are computing more favorably.