Claiming Foreign Taxes: Credit or Deduction?
If you invest in foreign markets and own stocks, bonds, mutual funds or income-producing investments, it’s likely that you paid foreign taxes on the income you earned. You may be able to avoid being taxed a second time on those investments if you claim 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 Forms 1099 or Schedules K-1 you received. For example, the 2020 and 2021 Form 1099-DIV lists the foreign taxes paid in box 7.
Should I take a tax credit or tax deduction?
Most of the time, it’s better to take a tax credit. 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 25% tax bracket, you would have to pay an additional $2,500 in U.S. tax on those foreign dividends ($10,000 multiplied by the 25% tax rate). Here’s how the credit or deduction would affect your tax bill:
- If you claimed a $1,000 foreign tax credit, you could reduce your $2,500 U.S. tax bill on the dividends dollar-for-dollar, to $1,500.
- If you claimed a tax deduction, that $1,000 of foreign taxes would be used to reduce your dividend income from $10,000 to $9,000. Your tax bill would be $2,250 ($9,000 multiplied by your 25% tax rate).
Generally, you must choose between a claiming 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.
It seems obvious that the tax credit is the best choice, and in most cases it is. The downside to the tax credit is that additional paperwork is required. If your foreign tax credit is more than $300 for a single filer ($600 for married couples filing jointly), you will have to prepare Form 1116 to get the credit. This form can be complex to complete, depending on how many foreign tax credits you are claiming (more on this below).
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 on that same income you would have owed $250 of U.S. taxes, 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 first carry the credit backward to your prior tax return, and then forward to future returns (up to 10 years). The ability to carry back or carry forward the unused tax credit only applies if you file Form 1116, and it is restricted by the amount of “excess limit” available in those years. The excess limit is created when the U.S. taxes on that foreign income are greater than the foreign taxes paid.
For example, if you have $100 in unused foreign tax credits, first look at the prior tax year and then at the subsequent tax years to see if you have excess limit available. If you have excess limit in those years, you can use the foreign tax credit to reduce your tax bill on those returns (this requires filing an amended tax return for the prior year).
US taxes on foreign income(A)
Foreign taxes paid(B)
|Prior tax year
|Subsequent tax year
In the example above, there is $50 of excess limit in the prior year and $75 of excess limit in the subsequent year. That means you can offset the $100 of unused foreign tax credits against the prior and subsequent returns, thereby reducing your taxes in those years, and still have $25 of excess limit to be used in the future.
Form 1116 can be complex
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. However, one problem with taking the credit is that Form 1116 can be complex.
Part of the reason the Form 1116 is complicated stems from the need to report the foreign taxes paid country by country. In addition, Form 1116 also requires you to figure the carryback or carryforward separately for each income category.
Fortunately, if you pay $300 or less in foreign taxes for the year ($600 for married couples filing jointly), you can claim the credit without having to fill out Form 1116, although additional eligibility rules apply. For example, to claim the foreign tax credit without filing Form 1116, all of your foreign income must be passive and reported to you on a form like the 1099 or schedule K-1.
For more information on calculating your allowable foreign tax credit, see Form 1116 instructions and IRS Publication 514.
Foreign taxes in a tax-deferred account
Unfortunately, you won’t be able to deduct foreign taxes you pay on investments held in a tax-deferred account, such as an individual retirement account (IRA) or 401(k). Since the income in those accounts is not currently subject to U.S. tax (at least not until you begin making withdrawals).
But don’t worry—you don’t lose the benefit of the foreign taxes you paid in those accounts, because the foreign taxes reduce the income earned in that account. It’s like you are taking a deduction against the income, and when you eventually withdraw the money, you are only taxed on the net amount. It’s similar to taking an itemized deduction for the foreign taxes.
If you have a Roth IRA, the situation is a bit different. Withdrawals from Roth accounts are not taxed by the IRS, so you’re not able to get a benefit from the foreign taxes you paid. But don’t let lack of tax benefit deter you from holding foreign investments in your Roth account; in some cases, it could still make sense to have foreign assets in those accounts. There are many other factors to consider apart from taxes when making investment decisions, such as diversification of your portfolio.
Get the facts on FATCA and FBAR
In order to prevent tax evasion, the U.S. government 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:
- FATCA for individuals
- Comparison of reporting requirements under FBAR and FATCA
Take charge of your taxes
Tax-smart financial planning has the potential to save you a lot of money in the long run. No matter how 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.