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Foreign Tax Credit

A solid understanding of the foreign tax credit can help minimize your investment-related taxes. What’s the foreign tax credit? The IRS explains it this way:

“If you paid or accrued foreign taxes to a foreign country on foreign source income and are sub­ject to U.S. tax on the same income, you may be able to take a credit for those taxes.”

In short, the idea of the credit is to eliminate double taxation on foreign income.

Example: You earn $500 in foreign dividend income over the course of the year and you pay $100 in foreign taxes on that income. You can claim a $100 credit for foreign taxes paid, thereby reducing your U.S. income tax obligation by $100.

Important note: Unless you meet three requirements, there is a limit to the credit you can take (please see IRS Publication 514 for details on the limit). The three requirements are as follows:

  • Your only foreign income is passive income (passive income being things like dividends, interest, and rents),
  • Your qualified foreign taxes for the tax year are not more than $300 ($600 if married filing jointly), and
  • All of your gross foreign income and the foreign taxes are reported to you on a payee statement such as a Form 1099-DIV or 1099-INT.

And now the fun part: How can you put this knowledge to use?

Use it to help determine your asset location.

Funds held in a retirement account–like an IRA or 401(k)–do not qualify for the credit even if they’re funds that would qualify were they held in a taxable account.

Does this mean that you should only buy international stock funds in taxable accounts rather than retirement accounts? No. Not at all. The benefit from tax-deferred or tax-free growth far outweighs this little credit.

If, however, you’re simply deciding which fund to hold in your retirement account (domestic stock fund vs. international stock fund) and which fund to hold in your taxable account, then it’s probably best to tax-shelter your domestic stock funds before tax-sheltering your international stock funds.

Claiming the Credit

Generally, you have to file Form 1116 to claim the foreign tax credit. If, however, you meet a few requirements (the same as the requirements listed above to avoid the limitation on the credit), you can simply enter your foreign taxes directly on Form 1040, line 47.

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