Link to original thread: Foreign Earned Exclusion: New Law Bad News
Appears that the new provisions that apply to foreign earned income exclusion have not been covered on this forum yet, except in the thread below:
Converting IRA to Roth during RNOR
So am taking the liberty of starting a new thread on this subject.
It contains bad news - hopefully the messenger wont be shot
The silver lining (count blessings, especially in bad times) is that what follows is about US taxation and not Indian taxation - so non-residents of India and RbutNORs under Indian tax law need not be unduly worried that the GOI tax exemption in respect of non-Indian source income that they currently enjoy has been taken away.
What follows would be of interest to current (and prospective) USCs residing outside US, and others who are required to or opt to file as US residents (for US tax purposes) when residing outside US.
The new tax law signed in May 2006 by President Bush applies from Jan 1, 2006 i.e. for tax year 2006 and beyond, and brings in a stacking provision in so far as foreign earned income exclusion is concerned, which is perhaps best explained via an example:
Say a USC has foreign (for work done outside US) earned (salary, wages, compensation, tips) income of $40K (which is excluded from gross income under the foreign earned income provision) and other income (investment income - rent, interest, dividends, ...) from $30K (included in gross income). For simplicity, assume that the other income is ordinary income and does not contain long term capital gains.
Prior to the new tax law, one paid tax only on the $30K at graduated tax rates (after availing standard deduction, personal exemptions), starting at the lowest tax slab. So, for the $40K excluded one effectively got tax relief at one's marginal tax rate and higher.
Now, under the new law, one needs to do the following:
(i) Determine tax first on $70K at graduated tax rates (after availing standard deduction, personal exemptions), starting at the lowest tax slab.
(ii) Then one needs to determine tax on $40K (the excluded portion alone) at graduated tax rates (after availing standard deduction, personal exemptions), starting at the lowest tax slab.
Tax liability is (i) - (ii).
So in effect, now one gets tax relief for the excluded income (foreign earned income) only at the lowest tax rates (including the "0% slab" in which one avails standard deduction etc) i.e. the $30K of income that is included gets taxed at rates that would apply had the foreign earned income exclusion not existed at all.
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Text of Relevant Portion of New Law (for those who have a taste for legalese)
Determination of Tax Liability on Nonexcluded Amounts- For purposes of this chapter, if any amount is excluded from the gross income of a taxpayer under subsection (a) for any taxable year, then, notwithstanding section 1 or 55--
(1) the tax imposed by section 1 on the taxpayer for such taxable year shall be equal to the excess (if any) of--
(A) the tax which would be imposed by section 1 for the taxable year if the taxpayer's taxable income were increased by the amount excluded under subsection (a) for the taxable year, over
(B) the tax which would be imposed by section 1 for the taxable year if the taxpayer's taxable income were equal to the amount excluded under subsection (a) for the taxable year, ....