By Jason Watson (Google+)
Self-employment income is taxed at two different levels- first, the net profit is taxed for social security and medicare benefits which is currently 15.3%. This is also referred to as self-employment (SE) tax. Next, your profit is taxed for personal income.
You can exclude your foreign income for personal income taxes, but you will still be responsible for the self-employment taxes. This can be quite a surprise for some business owners and self-employed taxpayers- if you earn $100,000 you will pay $15,300 in self-employment tax yet be exempt from personal income taxes. See the difference?
There are certain countries, such as the United Kingdom, where it makes sense to opt-out of the United States social security and medicare programs. Bilateral agreements or totalization agreements have been created, and can offer some relief (see What happens if my foreign country has a form of social security?).
There is another potentially big surprise too- the next tax dollar after the foreign earned income exclusion will be taxed at that income’s level. For example, if you earn $100,000 your marginal rate is 25%. If you exclude $99,200 (in 2014) of it, dollars $99,201 thru $100,000 will be taxed at 25% (Yes, this gets further reduced by deductions and exemptions). So, you are forced to leapfrog the benefits of the lower tax brackets. Bummer. But you did save over $30,000 in income taxes!