Should Americans in Canada use the Foreign Earned Income Exclusion or the foreign tax credit?

What each option does

The Foreign Earned Income Exclusion (FEIE) lets a US citizen living abroad remove earned income - salary, wages and self-employment profit - from US taxable income up to an annual cap. The cap is indexed each year; it is US$130,000 for the 2025 tax year, and you should confirm the current figure with the IRS before relying on it. It is claimed on Form 2555 and you qualify under one of two tests: the bona fide residence test (you were a genuine resident of Canada for a full calendar year) or the physical presence test (330 full days outside the US in any 12-month period). A separate housing exclusion can sit on top of it for employees with high housing costs.

The foreign tax credit (FTC) works differently. Your Canadian income stays on the 1040, and the Canadian income tax you paid on it is credited against the US tax on the same income, category by category, on Form 1116. Wages and business income sit in the general category; interest, dividends and capital gains sit in the passive category. Unused credits carry back one year and forward ten, so a surplus in a high-tax year is not wasted.

Why the credit usually wins for people living in Canada

The credit wins because Canada charges more tax than the United States on almost every dollar. Federal and Ontario rates combined exceed the US federal rate at every bracket, which means the Canadian tax you have already paid is nearly always enough to cover the US tax on the same income, with credits left over to carry forward. The exclusion removes income; the credit removes tax. In a high-tax country, removing tax is the more complete tool.

Four practical advantages follow from choosing the credit:

• It covers all income, not just earned income. The exclusion does nothing for interest, dividends, capital gains, rental income, RRSP withdrawals or pensions. Someone using the FEIE still needs Form 1116 for everything else, so they end up filing both forms anyway.
• It preserves the refundable child tax credit. If you exclude your earned income under the FEIE, you cannot claim the additional (refundable) child tax credit for that year. For a family in Canada with US-citizen children, that refund can be real money.
• It keeps IRA contributions open. An IRA needs taxable compensation to contribute against. Excluded income does not count, so a full FEIE claim can wipe out your ability to fund a Roth or traditional IRA.
• It avoids the stacking rule. Excluded income still sets the bracket for whatever income is left, so the FEIE does not reduce the rate on your remaining income the way people expect.

The credit also plays better with an RRSP. Contributions reduce your Canadian tax but not your US income, which narrows the gap between the two bills; the ten-year carryforward absorbs most of that mismatch. Our RRSP answer covers the US treatment in full.

When the exclusion still makes sense

The exclusion is worth a look whenever your Canadian tax is low relative to your income. Large RRSP or pension contributions, significant Canadian-only deductions, a partial year of work, or income from a low-tax third country can all leave you with less Canadian tax than the US would charge, and in those years the credit alone may not reach zero. It is also simpler: a young employee with one T4, no investments and no children can often file Form 2555 in minutes and be done.

You can combine the two. The FEIE can cover earned income up to the cap while Form 1116 credits Canadian tax on everything else, but the credit has to be scaled down for the Canadian tax that relates to the excluded income - you cannot exclude the wages and also claim credit for the tax paid on them. The combined route is where most mistakes happen on self-prepared returns.

Neither option touches US self-employment tax. Self-employed Canadian residents are generally covered by CPP under the Canada-US social security agreement and are exempt from US self-employment tax on that basis, but the exemption has to be claimed on the return; it does not come from Form 2555 or Form 1116.

The five-year lock and how switching works

Choosing the FEIE is an election that stays in force until you revoke it, and the revocation has teeth. Once you stop claiming the exclusion after having used it, you cannot claim it again for five tax years without a private letter ruling from the IRS, which is slow and expensive. Simply claiming the credit on all your income in a year after you used the FEIE is treated as a revocation. That is why we treat the choice as a long-term decision rather than a year-by-year optimization.

A common trap is the person who claimed the FEIE for years through tax software, then has a child, buys Canadian mutual funds or starts drawing a pension. The exclusion now costs them the refundable child credit and does nothing for the new income, but switching locks the door behind them. In that situation we model both routes over several years before changing anything. The same modelling belongs in the first return you ever file from Canada, which for many people happens through a streamlined catch-up where the choice is made for three years at once.

How we decide this for clients

We run the return both ways for the current year and project the next few, taking into account children, RRSP contributions, investment income and any planned move. For the large majority of people we prepare returns for in Canada the credit comes out ahead and we file Form 1116 with no election on Form 2555, keeping the exclusion available if circumstances change. Where the FEIE is already in force, we only revoke it when the multi-year picture justifies the lock-out. The full scope of what we prepare is on our US tax preparation page, and the wider context is in the dual citizen tax guide.

Source: IRS - Foreign Earned Income Exclusion and IRS - Foreign Tax Credit.