Why use the foreign earned income exclusion instead of foreign tax credit?

My second question for the day:

For US citizens living in the UK, why would you use the foreign earned income exclusion (FEIE) instead of the foreign tax credit (FTC)? As far as I can tell, UK income tax is higher than US federal income tax at every level, even not counting National Insurance contributions (which don't count for the FTC). So the FTC would always completely offset your US tax liability. Plus you get some advantages:

1. You can carry over excess FTC for 10 years into the future (handy if you have a big windfall coming up that's not taxable in the UK, but is taxable in the US, such as 25% lump sum pension payouts).

2. You can use the FTC to counteract US taxation on passive income in the UK, such as bank interest, dividends, etc (which isn't earned income, therefore not eligible for the FEIE). At some income levels, bank interest would be taxed at 20% in the UK, but 25% in the US (because even if you use the FEIE, your marginal tax rate remains as if you hadn't used the FEIE). Okay, in most cases your passive income would fall under the level of the standard deduction and personal exemption, but in some cases not.

Yet I've read articles arguing that FEIE is actually better than FTC, even if the foreign tax rate is higher than the US tax rate (as it is the UK), as long as your salary is below the FEIE threshold. (e.g., here: http://findarticles.com/p/articles/mi_6773/is_1_7/ai_n28522856/ [nofollow] ) Am I missing something?

Another possible use for the carryover of FTC: It seems that redundancy payments are tax-free in the UK up to £30k, but I've never heard of anything like this in the US. I can't tell from the IRS guidance if a redundancy payment would be considered "earned income" or not.

You can use both. You can use the FEIE for your wages and the FTC for other income, like interest or dividends.

I think most people don't earn enough money to go over the FEIE threshold, so taking that immediately reduces their taxable foreign earned income to $0.

Right. But in some cases the FTC on passive income alone would not be enough to completely negate your US taxation on that passive income - e.g., if you have a cash ISA (US taxable, but not UK taxable), or if you're in the income zone where UK taxes interest at 20% and the US taxes it at 25%. So it sounds like I am correct that in these situations, you're better off forgoing the FEIE and using the FTC instead, so that you can use the surplus FTC from your salary on the US taxation on your passive income.

Unless you have high tax kickout income (eg not from an ISA) the passive income would be seperately basketed so you could still owe US taxes on passive income.

Revoking the section 911 exclusion is a choice you can only make every 5 years so may not suit the cautious taxpayer.

Ah, I see. I didn't realize about the separate baskets. For anyone else who didn't realize, it's in Publication 514:

http://www.irs.gov/publications/p514/ar02.html [nofollow]

That suggests that neither of the advantages of the FTC that I suggested can be realized by my not-so-clever strategy, which I guess is a loophole that the IRS has thought of. After all, the lump sum 25% pension payout in the UK would surely be classified as "passive income", so you can't carry over excess FTC from "general category income" to apply in future years to "passive category income." That would suggest that the strategy suggested by masterblaster here would not work: http://talk.uk-yankee.com/index.php?topic=46263.msg652324#msg652324 [nofollow]

However, about the pensions (to shift topics slightly): am I correct in thinking that the US would not tax the 25% lump sum from UK pensions due to the tax treaty? (Article 17, paragraph 1-2 - http://www.ustreas.gov/offices/tax-policy/library/uktreaty.pdf [nofollow] )

Now, about revoking the section 911 exclusion: I read the revocation bit (http://www.irs.gov/businesses/small/international/article/0,,id=97026,00.html [nofollow] ) as meaning that revocation is when you first claim the FEIE for a tax year, then change your mind, and this then means that if you want to claim the FEIE again within 5 years, you must get approval. But it seems to me that if in one year you just don't claim FEIE, that doesn't count as "revocation" and thus isn't subject to this revocation rule. Is that right?