If you're looking for ways to diversify your portfolio, international investments might be an option. For one, economic, political, or cultural events can affect market performance in the U.S. differently than they might overseas. Also, emerging markets offer another opportunity for potential growth.
But foreign investments may lead to foreign taxes. If you own stocks, bonds, mutual funds, or income-producing investments in global markets, it's likely that you'll pay foreign taxes on your earnings. You may be able to avoid double taxation on those investments by claiming a credit or deduction on your U.S. tax return.
How do I know if I paid foreign taxes?
The simplest way to see if you paid foreign taxes is to look at the 1099 forms or K-1 schedules you receive. For example, the 2022 Form 1099-DIV lists the foreign taxes paid in box 7.
Should I take a tax credit or tax deduction?
In most cases, you're probably better off taking the credit rather than claiming an itemized deduction, even if the credit you claim is limited. Tax credits reduce your tax bill dollar-for-dollar, which means a $500 tax credit will save you $500 in taxes. A tax deduction only reduces your taxable income, meaning a tax deduction's benefit is equal to the reduction in taxable income multiplied by your tax rate.
For example, let's say you received $10,000 in foreign dividends, and you paid $1,000 in foreign taxes on that income. If you're in the 24% tax bracket, you would have to pay an additional $2,400 in U.S. tax on those foreign dividends ($10,000 x 0.24). Here's how the credit or deduction would affect your tax bill:
- If you claim a $1,000 foreign tax credit, you could reduce your $2,400 U.S. tax bill on the dividends dollar-for-dollar to $1,400 ($2,400 – $1,000).
- If you claim a tax deduction, you could use the $1,000 of foreign taxes to reduce your dividend income from $10,000 to $9,000—lowering your tax bill to $2,160 ($9,000 x 0.24).
Generally, you must choose between claiming either a credit or a deduction—you're not normally allowed to do both in a single year. However, you can change which one you choose each tax year.
How to claim the foreign tax credit
The IRS limits the foreign tax credit you can claim to the lesser of the amount of foreign taxes paid or the U.S. tax liability on the foreign income. For example, if you paid $350 of foreign taxes and owed $250 of U.S. taxes on that same income, your tax credit will be limited to $250.
So, what happens to that leftover $100 of foreign tax credit? Fortunately, it's not lost. The IRS allows you to carry the credit backward to your prior tax return first and then carry it forward to future returns (up to 10 years).
Let's look at how this would work. First, review the prior tax year, and then look at the subsequent tax years to see if you have excess limit available. (The excess limit is created when the U.S. taxes on that foreign income are greater than the foreign taxes paid.)
Prior and Subsequent Tax Years
|US taxes on foreign income (A)||Foreign taxes paid (B)||Excess limit (A)-(B)|
|Prior tax year||$300||$250||$50|
|Subsequent tax year||$325||$250||$75|
In the example, you have $50 of excess limit in the prior year and $75 in the subsequent year—a total of $125. You can use the $100 of unused foreign tax credits to reduce your tax bill on the prior and subsequent returns, leaving $25 of excess limit to be used in the future. This requires filing an amended tax return for the prior year, and you might need to file Form 1116 to be eligible for the credit.
You must prepare Form 1116 if your qualified foreign taxes are more than $300 for a single filer ($600 for married couples filing jointly), the income is non-passive, or your gross foreign income and taxes were not reported on a payee statement (such as a 1099). This form can be complex to complete, depending on how many foreign tax credits you are claiming.
Part of the reason the Form 1116 is complicated stems from the need to report the foreign taxes paid country by country. You must also figure out the carryback or carryforward separately for each income category.
For more information on calculating your allowable foreign tax credit, see Form 1116 instructions and IRS Publication 514.
Foreign taxes in retirement accounts
Unfortunately, foreign investments in retirement accounts don't qualify for either a tax credit or deduction.
Because income in a tax-deferred account—such as an individual retirement account (IRA) or 401(k)—isn't subject to U.S. tax (at least not until you begin making withdrawals), you can't deduct foreign taxes paid on investments held in the account. But don't worry—the foreign taxes reduce the income earned in that account. That is, when you eventually withdraw funds from your account, you'll be taxed on the net amount only.
If you have a Roth IRA, the situation is a bit different. Withdrawals from Roth accounts are tax-free, so you won't benefit from the foreign taxes you paid. But don't let the lack of a tax benefit deter you from holding foreign investments in your Roth account; it could still make sense to include foreign assets for diversification and potential growth.
Take charge of your taxes
Tax-smart financial planning has the potential to save you money in the long run. No matter if you choose to handle your foreign taxes as a credit or a deduction, be sure to claim the option that makes the most sense for your situation. Otherwise, you could end up paying more than you should.
Get the facts on FATCA and FBAR
To prevent tax evasion, the U.S. government has implemented Foreign Account Tax Compliance Act (FATCA) and the Foreign Bank Account Report (FBAR) requirements. The reporting requirements created by these laws are complex, and there are significant penalties for failure to comply. If you hold a title—directly or indirectly—to a foreign financial account or trust, you should consult with a tax professional for questions about individual compliance matters.
For more information on FATCA and FBAR, see the IRS resources below:
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Investing involves risks, including loss of principal.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.0223-3PDH