Weak Dollar Crushing the Foreign Earned Income Exclusion

If you are using the Foreign Earned Income Exclusion and are paid in a foreign currency, your U.S. taxes may have tripled in the last few years! This is because the value of the FEIE is falling fast, along with the value of the US dollar. Let me explain.

Editors Note: This post was written in January of 2013. Since then, the dollar has soared and other currencies have faltered. This article is still helpful in understanding how to calculate the FEIE and, like all things, currency valuations are cyclical.

The Foreign Earned Income Exclusion allows you to exclude $97,600 in 2013 from your Federal Income Taxes. This exclusion amount goes up most years and is indexed to inflation. For example, the Foreign Earned Income Exclusion was $91,400 for 2009, $91,500 for 2010, $92,900 for 2011, $95,100 for 2012. For additional information on the FEIE, please see my article on taxation, or click here for About.com.

When you report your foreign salary, you must translate from your local currency into U.S. dollars. If your currency is strong compared to the dollar, as most are, your U.S. tax bill will increase as the dollar weakens.

Here is an example from a group of tax returns I prepared this month:

This client is living and working in Japan and needed to catch up on his delinquent Federal 2009, 2010 and 2011 returns, and file his 2012 return. His salary has remained constant for these years at 12,000,000 Yen.

Using the yearly average charts on the IRS site for 2009, 2010 and 2011, and Oanda for 2012, here are the approximate conversion amounts:

• ¥12M is $123,250 in 2009, compared to a FEIE of $91,400.
• ¥12M is $131,370 in 2010, compared to a FEIE of $91,500.
• ¥12M is $144,400 in 2011, compared to a FEIE of $92,400.
• ¥12M is $150,500 in 2012, compared to a FEIE of $95,100.

If this client had earned the same salary of 12M Yen in 2006, the conversion to U.S. dollars would have been $97,938 against a Foreign Earned Income Exclusion rate of $82,400.

So, even as the buying power of this client’s salary has done down over the years (no increase for inflation, etc.), his U.S. taxes have skyrocketed. In 2009, his net taxable income (salary in US$ minus FEIE) was $31,850. In 2012, his net taxable income is $55,400. Had this client earned ¥12M in 2006, his net taxable income would have been only $15,500. This means his taxable income has increased by a multiple of 3.5 since 2006!

There are a few planning tools you might use to mitigate these affects. For example, when reporting your salary, there is no exchange rate mandated by the IRS. The only requirement is that you be consistent year to year and use a published rate. If your salary is about the same each month, then a yearly average exchange rate is the most accurate. If you receive a large bonus at the end of the year, or other incentives, you may benefit from a more complex calculation. In that case, I generally recommend www.oanda.com, www.xe.com or www.x-rates.com.

The Foreign Earned Income Exclusion remains the most important tool in the Expat’s tax toolbox, but its value is falling fast, just as your tax rates continue to climb. This means that other tools, such as foreign corporations for the self-employed and the ability to retain earnings offshore are becoming even more important.