A Primer on How to Be Tax-Smart with Your Foreign Income
Do you own stocks, bonds, or mutual funds? If so, you may well have some foreign holdings such as BMW (German), or BP (British), or Nestle (Swiss). This means you have paid foreign taxes on the income you earned. Would you like to avoid being taxed on that income a second time? You may be able to accomplish this goal if you claim a credit or deduction on your U.S. tax return. Don’t count on your tax preparer or preparation software doing this optimally for you.
The information below applies to almost all U.S. investors since most hold foreign stocks in their U.S. mutual funds. Read on to learn how to be more tax-efficient with your foreign income.
Wait – How Do I Know if I Paid Foreign Taxes?
This is an important question and one that is actually fairly easy to answer. Just look at the Forms 1099 or Schedules K-1 you received. You’ll see a “foreign taxes paid” box on each.
Tax Credit Versus Tax Deduction: Which Should I Take?
More often than not, it’s better to take a tax credit because they offer a dollar-for-dollar reduction on your tax bill. So, a $500 credit equals $500 in tax savings. Conversely, a tax deduction will only reduce your taxable income.
Here’s an example: Let’s say you received $10,000 in foreign dividend earnings, and you already paid $1,000 in foreign taxes on said income. If you fall into the 25 percent tax bracket, you would pay an additional $2,500 in U.S. income tax on those foreign dividends ($10,000 multiplied by your 25 percent tax rate). Now, let’s look at how either a credit or a deduction would impact your tax bill:
Credit
Claiming a $1,000 foreign tax credit in this scenario would reduce your $2,500 tax bill by $1,000. So, you would only owe $1,500.
Deduction
Claiming a tax deduction here would mean that $1,000 of foreign taxes would reduce your dividend income from $10,000 to $9,000. This would make your tax bill $2,250 – $9,000 multiplied by your 25 percent tax rate.
Typically, you must choose between taking a deduction or claiming a credit – you cannot usually do both in a single tax year. However, you can always change which you choose in each new tax year. As illustrated by the example above, the tax credit is usually going to be your best option. The only downside is that there is additional paperwork required, in the form of Form 1116, which can be a bit complex.
So, How Do I Claim a Foreign Tax Credit?
The IRS places limitations on foreign tax credit. You are permitted to claim the lesser of the amount of foreign taxes paid or the U.S. tax liability on the foreign earnings. So, for instance, let’s say you paid $350 on foreign taxes and you owe $250 in U.S. taxes. You are limited to a credit of $250.
Where does that leftover $100 go? Luckily, it’s not lost. The IRS will permit you to carry that credit backward to your prior-year tax return and then forward to future returns for ten years into the future. This carry-backward or carry-forward benefit only applies if you’ve filled out Form 1116, mentioned above.
More on Form 1116
The IRS is infamous for its paperwork, and this form is a doozy. Its complex nature stems in part from the fact that you must report the foreign taxes paid country by country. You also have to carry-back or carry-forward separately for each of your income categories. The silver lining is that, if you pay less than $300 in foreign taxes for the year (or less than $600 for married couples filing jointly) you can claim your credit without having to submit Form 1116.
There are additional eligibility rules to be aware of, as well. For instance, in order to claim the foreign tax credit without filing Form 1116, your foreign income must be completely passive and reported to you on a 1099 or Schedule K-1.
To read up further on Form 1116, you can check out the form instructions here, as well as this helpful IRS publication.
What About Foreign Taxes in a Tax-Deferred Account?
The bad news is, you won’t be able to deduct foreign taxes you paid on investments held in a tax-deferred account. This includes both traditional IRA accounts and 401(k) accounts. The income in those accounts is tax-deferred, meaning it is not currently subject to U.S. income tax (which is triggered when you begin making withdrawals), so the IRS will not permit a deduction or a credit for the foreign taxes you paid.
Keep in mind, though, that you don’t lose the benefit of the foreign taxes you paid on these accounts – the foreign taxes reduce the overall income earned in that account. So, it’s as if you are taking a deduction against the income. Later, when you withdraw money, you will only be taxed on the net amount. So, this is actually similar to taking an itemized deduction for the foreign taxes you paid.
Roth IRAs are a bit of a different story. Withdrawals from Roths are not subject to U.S. tax because they represent after-tax contributions already. So, you’re not able to get any benefit from the foreign taxes you paid. This doesn’t mean you shouldn’t hold foreign investments in a Roth account, though – it still makes sense in some cases. There are plenty of factors besides taxes to consider when you make investment decisions, including things like portfolio diversification.
What You Should Know About FATCA and FBAR
The U.S. government has several laws in place to prevent tax evasion. The Foreign Account Tax Compliance Act (FATCA) and the Foreign Bank Account Report (FBAR) contain reporting requirements with significant penalties if you fail to comply. If you hold a title, either direct or indirect, to a foreign trust or financial account, it is in your best interest to consult with a tax professional to ensure you are complying with these regulations.
Can I Rely on My CPA or Tax Prep Software for Foreign Taxes?
The information above can be confusing and overwhelming, and it’s common to rely on your CPA or your favorite tax prep software to iron everything out for you. While many CPAs will get it right, especially if they commonly work with ex-pats or specialize in foreign income tax work, it’s best to ask questions to ensure you’re dotting your I’s and crossing your T’s. When it comes to DIY tax prep software, you’ll need to be careful. For example, if you use TurboTax, you’ll need the Deluxe or higher editions in order to claim foreign earned income.
What About Portfolio Management Implications?
As mentioned above, the issue of foreign taxes applies to nearly every U.S. investor. So, if you’re reading this article, you need to consider how your portfolio is being managed. At WellAcre, we factor in tax efficiency when allocating portfolios, and we recommend that all investors ensure their financial advisor does so, too. In particular, this means appropriately allocating assets between taxable, Roth, and Tax-Deferred accounts to ensure maximum after-tax return.
Ready to Take Charge of Your Foreign Taxes?
Getting tax-savvy is an important aspect of your financial planning, and it can save you a great deal of money over time. Regardless of whether you choose to claim a credit or a deduction, do so with an informed understanding of what makes the most sense for your personal situation.
At WellAcre, we’ll help you carefully construct a financial plan that accomplishes your goals through a strategy you can follow consistently over time. Contact us today to learn more about how our expertise in cross-border financial planning can help you conquer your foreign taxes and much more.
