Foreign earned income exclusion vs tax credit

If you live in a country with higher taxes than the US, the foreign tax credit usually wins. In a low-tax or no-tax country, the exclusion usually does. The fine print decides the close calls.

The short version

Form 2555 (foreign earned income exclusion) excludes foreign earned income up to $130,000 for tax year 2025 and $132,900 for tax year 2026, plus a housing amount for some people [1][3].
Form 1116 (foreign tax credit) subtracts foreign income tax you paid from the US tax on the same income, dollar for dollar, on earned and unearned income [4][5].
To use the exclusion, you need a foreign tax home and must pass the bona fide residence test or the 330-day physical presence test [2].
You can't claim a credit for foreign tax on income you've excluded [2][4]. Once you revoke the exclusion, you generally can't choose it again for 5 tax years without IRS approval [3][8].
Neither one removes US self-employment tax. Only a totalization agreement can do that.

How the exclusion works (Form 2555)

Think of the exclusion as Uncle Sam agreeing to look the other way on a chunk of your paycheck. It takes qualifying foreign earned income (wages, salary, bonuses, freelance and business profits for work done abroad) off your taxable income, up to a yearly cap. It doesn't cover pensions, Social Security, interest, dividends, capital gains, rent or US government pay [2][3].

Who qualifies

You need all three, no partial credit [2]:

Foreign earned income, meaning pay for work you physically did outside the US.
A tax home in a foreign country. Your main place of work must be abroad, and you can't keep your "abode" in the US. If your closer ties stay back home in the States, you don't qualify [2].
One of two tests: - Bona fide residence test: a US citizen (or a resident alien from a treaty country) who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year [2]. It's about where you've really put down roots (a residence permit, a home, family and local taxes), not a day count. - Physical presence test: 330 full days in a foreign country or countries during any 12 consecutive months [1][2]. A "full day" is a 24-hour day from midnight to midnight. Days in transit over international waters or in the US don't count, so that Thanksgiving trip home eats into your margin. The 12-month window can straddle two calendar years, which helps in your first and last years.

If you've just moved and haven't met either test by the time your return is due, file Form 2350 to get an extension until you can [7].

How much you can exclude

Tax year	Maximum exclusion per person	Housing expense limit (most locations, full year)
2025	$130,000	$39,000
2026	$132,900	$39,870

Sources: IRS foreign earned income exclusion figures [1] and the 2026 Form 2555 instructions [3]. In a part year, the exclusion is prorated by qualifying days. Two spouses who both work abroad and both qualify can each exclude up to the maximum on a joint return [7].

The housing exclusion or deduction

On top of the main exclusion, you can exclude (if employed) or deduct (if self-employed) part of your foreign housing costs: rent, utilities other than phone and TV, insurance and parking [3]. You only get the amount above a base amount, which is set by law at 16% of the maximum exclusion, and only up to the housing limit [9]. The general limit is 30% of the maximum exclusion. That's $39,870 for 2026 [3], or $109.23 a day for a part year. Certain high-cost locations listed in an annual IRS notice get a higher limit [3]. For 2026, that notice is Notice 2026-25 [3].

The catch nobody mentions: stacking

Here's the gotcha. Excluded income still pushes up the rate on whatever income you don't exclude. You figure tax on the rest "using the tax rates that would have applied" if you hadn't excluded anything, with the Foreign Earned Income Tax Worksheet [3]. A $50,000 US rental profit on top of a $130,000 excluded salary is taxed at the rates for $180,000, not the rates for $50,000.

How the credit works (Form 1116)

If the exclusion is Uncle Sam looking the other way, the credit is him giving you credit for tax you already paid somewhere else. It's a dollar-for-dollar credit for foreign income taxes you paid or accrued, against the US tax on the same foreign income [4]. VAT, sales tax and property tax don't qualify. Only foreign income taxes and similar taxes imposed on you count [4]. You can take foreign taxes as an itemized deduction instead, but in most cases the credit is the better deal [4].

Key mechanics, per the 2025 Form 1116 instructions [5]:

Income is sorted into categories, mainly general category income (wages, business income) and passive category income (interest, dividends). The credit is limited separately in each category, so high tax on your salary can't offset US tax on your dividends.
The $300/$600 shortcut. You can skip Form 1116 if all your foreign income is passive, it was reported on a payee statement such as a 1099, and your creditable foreign taxes are no more than $300 ($600 on a joint return). If you use this, you can't carry over any excess for that year [5].
Carryovers. Unused foreign tax credit in a category can generally be carried back one year and forward ten years [10]. That's handy if you move from a high-tax country to a lower-tax one.
Treaty re-sourcing. Certain income re-sourced by a tax treaty goes in its own category [5].

Because the credit covers unearned income too, it's the only one of the two that can shelter a foreign pension, foreign rent or foreign investment income from double tax.

Which suits your country

Your situation	Usually better	Why
High-tax country (e.g. much of Western Europe, Canada, Australia, Japan)	Foreign tax credit	Foreign tax exceeds US tax, leaving no US tax and excess credits to carry forward
No or low income tax (e.g. UAE, Saudi Arabia, Bahamas, Cayman Islands)	Exclusion	No foreign tax to credit, so the exclusion is the only relief on wages
Salary well above the exclusion cap in a mid-tax country	Credit, or both together	The exclusion covers the first slice, the credit covers the rest
Children and refundable credits matter	Often the credit	The exclusion removes earned income that some refundable credits are based on
Contributing to a US IRA	Often the credit	Excluded income can't support IRA contributions
Self-employed with no totalization agreement	Either for income tax, but SE tax remains	Neither form removes self-employment tax

These are rules of thumb, not rules. Many expats mix and match: the exclusion for salary up to the cap, and the credit for foreign tax on income above the cap or on investment income. You can't credit the foreign tax on income you excluded. The IRS says you can't take a credit "for taxes on income you can exclude" [2][4].

Self-employment tax

Freelancers, heads-up: the exclusion reduces income tax, not the 15.3% US self-employment tax on net earnings. The Form 2555 instructions even disallow deducting the part of self-employment tax tied to excluded income [3]. If you're self-employed abroad, check whether your host country has a totalization agreement with the US. If it does, a certificate of coverage from that country can exempt you from US self-employment tax.

Making the choice, and why switching is costly

Model both for the current year, and for the next few if your income or country is likely to change.
Choose the exclusion by completing Form 2555 with a timely return (including extensions), an amended return, or a late return filed within one year of the original due date [6].
Know that it sticks. This isn't a pick-again-every-April decision. The choice stays in effect for later years until you revoke it [6].
Revoke only on purpose. If you revoke, you can't claim the exclusion for the next 5 tax years without IRS approval [3]. Getting approval means a private letter ruling request, with a fee [8].

Moving from Dubai to Berlin is a textbook case for switching from the exclusion to the credit. Going the other way, from Berlin to Dubai, can come back to bite you if you revoked recently. A US expat tax preparer can run both versions for your numbers.

Foreign earned income exclusion vs foreign tax credit: which one cuts your US tax more