Are there any downsides to claiming the foreign earned income exclusion?
Yes, but the exclusion is a very nice tax break. First, you cannot claim a foreign tax credit or a foreign tax deduction on the income you exclude. Generally speaking any credit or deduction that you normally would be allowed to take cannot be taken on the excluded income (IRS frowns on double-dipping).
Second, you will not be eligible for the earned income credit. In other words, you can’t end up with $5,000 of taxable income since you excluded $99,200 (in 2014), and then claim that you need additional assistance through the Earned Income Credit program.
Another problem comes up with dependent care benefits (daycare) or education benefits. If these credits would normally have been phased out due to high incomes, the foreign earned income exclusion cannot reduce your income to below those phase-outs.
As mentioned earlier, 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!