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How Foreign Tax Credits Work

        Money | Taxes

Credit vs. Deduction vs. Exclusion

The foreign tax credit is one benefit available to taxpayers who earn money from outside the U.S., but it isn't the only one. Tax filers may also be entitled to a foreign tax deduction or to seek an exclusion for some of the money they make [source: IRS].

Before you can decide which option — or options — is best for you, it's important to understand the terminology. A tax credit reduces the money you owe at the end of the year on a dollar-for-dollar basis. So if you owe $5,000 and you get a $3,000 credit, the tax man will expect to get $2,000 from you. A deduction, on the other hand, reduces your total taxable income. A person who makes $50,000 in taxable income over the year and takes a $3,000 foreign tax deduction will be taxed as if he or she made $47,000 [source: IRS].

The IRS generally advises taxpayers to take the foreign tax credit rather than the deduction because it is likely to mean more tax savings for most people. Claiming the deduction may also be more work, as it requires filing an itemized Form 1040 Schedule A. U.S. taxpayers can't claim the foreign tax credit and foreign tax deduction in the same year [sources: IRS, IRS].

A person also can't claim a credit or deduction for foreign income he or she excludes when calculating tax obligations. The foreign earned income exclusion is available to citizens who either live in another country for the entire tax year, or reside in the U.S. but is a citizen or national of another country with which the U.S. has a tax treaty. These individuals can exclude up to $99,200 in income in 2014, meaning that this money isn't counted as part of their income for U.S. tax obligation purposes. A similar exclusion is also available for foreign housing costs [sources: IRS, IRS].