Qualifying for the credit.
To qualify for the credit, the foreign tax must meet four tests:
Generally, only income taxes paid or accrued to a foreign country or a U.S. possession (also referred to as a U.S. territory), or taxes paid or accrued to a foreign country or U.S. possession in lieu of an income tax, will qualify for the foreign tax credit. Qualified foreign taxes do not include:
- Taxes refundable to you.
- Taxes used to provide a subsidy to you or someone related to you.
- Taxes not required by law, because you could have avoided paying the taxes to the foreign country.
- Taxes that are paid or accrued to a country if the income giving rise to the tax is for a period (the sanction period) during which:
Note: These taxes may be claimed as an itemized deduction.
Choosing a credit or a deduction.
Generally, you must choose to take either a credit or a deduction for all your qualified foreign taxes. For those who itemize deductions on Schedule A of Form 1040, taking a deduction for foreign taxes paid may be the easiest way to go. However, an itemized deduction only reduces your taxable income, whereas an income tax credit can provide a dollar-for-dollar reduction of your actual tax liability.
For example, if you’re in the 33% income tax bracket, a $200 deduction would only reduce your taxes by $66 (assuming full deductibility), whereas a tax credit would provide a $200 reduction in tax liability (if you are eligible for the entire credit). Taking a tax credit seems like the obvious choice, right? Unfortunately, the foreign tax credit has limitations and requires you to fill out Form 1116, which can be complex.
You must choose either the foreign tax credit or itemized deduction for all foreign taxes paid or accrued during the year. This is an annual choice.
If you are a cash basis taxpayer, you can only take the foreign tax credit in the year you pay the qualified foreign tax unless you elect to claim the foreign tax credit in the year the taxes are accrued. Once you make this election using IRS Form 1116, you cannot switch back to claiming the taxes in the year paid during later years.
Since you don’t pay current taxes on investment income in your IRA or 401(k), there’s no deduction or credit currently available for foreign taxes paid on investments held in these accounts.
No matter how you choose to handle your foreign taxes, just be sure to claim a credit or a deduction. Otherwise, you could end up paying more than you should.
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