Claiming Foreign Taxes: Credit or Deduction?

Key Points

  • If you own foreign investments, you're probably paying foreign tax.   
  • You can avoid double taxation by claiming either an itemized deduction or a tax credit on your income taxes. 
  • You may be required to report foreign accounts to the IRS.

If you own foreign investments—either directly via a stock or bond, or indirectly through an exchange-traded fund or mutual fund—the issuing foreign country may withhold taxes on your investment income.

Fortunately, U.S. tax law prevents double taxation by allowing you to claim either an itemized deduction for foreign taxes paid (or accrued), or a foreign tax credit on your U.S. income tax return.

Tip: Find out if you paid foreign tax

Take a look at Form 1099-DIV. Annual foreign taxes paid should be listed in Box 6.

Itemized deduction or tax credit?

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 is 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 (more on this below).

Claiming a credit

The amount of foreign tax credit you're allowed to claim is limited to the lesser of the amount of foreign tax paid or the U.S. tax liability on the same income.

EXAMPLE  
IF foreign dividend income = $1000
AND foreign tax due = $350
AND U.S. tax due = $250
THEN maximum foreign tax credit = $250

If your U.S. tax liability were the same or higher than the foreign tax paid, you would be eligible to claim the full credit. In other words, you avoid double-taxation but always end up paying tax at the highest tax rate.

If you paid more foreign tax during the current year than you can claim as a credit, you can carry back the excess for one year (that is, file an amended return for the previous tax year) or forward the excess for 10 more years. The ability to carry back or carry forward any unused tax credit only applies if you file Form 1116, and is restricted by the amount of excess limit available in those carryback or carryforward years.

For example, if you pay $350 in foreign tax but only owe $250 in U.S. tax on the same amount, you would have $100 in unused foreign tax that you could carry forward or carry back. However, in order to apply that amount to future tax years (or the previous tax year), you need to have excess to use in those tax years.

EXAMPLE  
IF foreign tax paid in current year = $350
AND current year U.S. tax due = $250
THEN potential carryback to prior year or forward = $100

In the hypothetical example below, you could either carryback or carryforward that $100 because both years have an excess limit of at least $100.

  Credit limit Taxes paid Unused foreign tax (+) or excess limit (-)
Prior year $400 $250 -$150
Current year$250$350+$100
Next year $350 $250 -$100

Even if you're limited in the amount of credit you can claim, you're probably better off taking the credit rather than claiming an itemized deduction in most cases. One problem with taking the credit, however, is that Form 1116 is complex and can take a lot of work to complete.

Even when using tax-preparation software or a professional preparer, you still have to figure out how much foreign tax was paid to each separate country. In the case of mutual funds, this information is generally provided by the fund annually but the IRS will allow you to aggregate foreign sourced income for mutual funds on Form 1116 (see links to Form 1116 Instuctions and IRS Publication 514 below).

You'll also need to figure your carrybacks or carryforwards separately for each limit income category. The passive income category, which includes dividends and interest income, is one of five income categories.

Fortunately, if you pay $300 or less in foreign taxes for the year ($600 for married filing jointly), you can claim the credit without having to fill out Form 1116, though additional eligibility rules apply.

For example, all of your foreign income must be passive income and reported to you on a payee statement such as Form 1099-DIV or Form 1099-INT. See the Form 1116 Instructions and IRS Publication 514 for more detailed information.

Deferred accounts

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.

Think of it as a timing issue: The amount you pay in foreign taxes today reduces your retirement assets, and therefore reduces the amount of tax the IRS is able to collect when you start making withdrawals.

A Roth account is another story since qualified withdrawals are tax-free in the United States. In the case of a Roth, you're just out the money. However, it could still make sense to hold foreign investments in tax-advantaged retirement accounts. There are many other factors to consider apart from what might be a relatively immaterial amount of foreign tax.

Get the facts on FATCA

In an ongoing effort by the federal government to prevent illegal activities through the use of offshore accounts and trusts, FATCA (Foreign Account Tax Compliance Act) is designed to enhance existing U.S. law surrounding the reporting and withholding requirements connected to foreign accounts. Foreign account and asset ownership reporting is a complex area with significant penalties for failure to comply.  If you hold a title, directly or indirectly, to a foreign financial account or trust you should consult your own tax professional for questions about individual compliance matters.

FATCA is closely related to the FBAR (Report of Foreign Bank and Financial Accounts). For more information on both, here are some IRS resources that you might find helpful:

Take charge of your taxes

No matter how you choose to handle your foreign taxes, just be sure to claim something. Otherwise, you could end up paying more than you should.

I hope this enhanced your understanding of taxes. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

 

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