An explanation of the weird Form 1116, and how to get the most out of the credit.
It’s not hard to get credit for taxes withheld on your overseas dividends, says Lisa Greene-Lewis, a CPA at Intuit’s TurboTax. Download your broker’s 1099 electronically, then use the software’s interview option to answer some plain-English questions. That way you don’t have to decipher the insanely complicated IRS formulas for figuring the foreign tax credit.
Good enough, if all you want to do is file a return and be done with it. But if you want to be a wise investor, you really have to understand what’s going on inside that software. Crucial point: If you step one dollar over a certain red line, you’re suddenly out thousands of dollars.
Foreign stocks have their attractions. They tend to be cheaper in relation to earning power than U.S. stocks, and to have better payouts. The average dividend yield in Europe, for example, is double the 1.3% you see in the U.S. But once you venture abroad, you have tax collectors in two nations after you.
Typically your foreign dividends will be clipped for an income tax withheld in the issuer’s home country. The going rate is 15%, although there are variations up and down from that point. The good news is that you can get much of that money back—on occasion, all of it—when you file your U.S. return. But only if you play the game correctly.
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The concept with tax credits is that you shouldn’t have a double tax burden when you cross a border. If you work in New York and live in New Jersey, New York will take a piece of your salary. When you file your New Jersey return, New Jersey gives you a credit for the tax it imposes on that salary.
So, too, if you collect a $1,000 dividend from a French drug company, France will nick you $150. If you’re in the 15% federal bracket for dividends (most dividend recipients are) and if the dividend is “qualified” (most of big-company payouts are), then you owe $150 of federal tax. You should be able to fully credit the French tax against the U.S. tax, so that there’s no double duty.
Except that this is not necessarily what happens when the numbers are cranked into the IRS worksheets. The baroque rules for claiming the foreign tax credit mean that you might get full credit for what you already paid, or you might get only half, or you might get less than half.
The formulas have you carving up foreign income into separate calculations for different kinds of income (salaries here, dividends there) and separate buckets for each country. They are sufficiently bizarre to trip up even the most sophisticated taxpayers.
Scott Hoppe, a San Francisco CPA, says he had occasion to prepare an amended federal return for a client who was a partner in a multinational law firm with a welter of overseas tax bills. Redoing the Form 1116, Foreign Tax Credit, saved her $60,000.
For passive investors with no overseas income but dividends, the rules are only somewhat less forbidding than they are for jet-setting law partners. Threshold question: Are your foreign equities in a taxable account or a tax-deferred one (like an IRA)?
If the investment is inside the IRA, your tax return will be simple but you will be missing out. That’s because the retirement account cuts no ice with foreign tax collectors. You’re simply out the 15% withholding tax, and there is no way to credit that tax against your U.S. tax bill.
From here on, we’ll assume you are taking the usual approach, which is to put foreign stocks in a taxable account, take advantage of the reduced U.S. tax rates that apply to most dividends and get what you can from the credit.
Case I: Foreign taxes less than $600. This is likely if your overseas holdings come to less than $100,000. No special effort is required. You can claim the foreign tax dollar-for-dollar against your U.S. liability and you don’t have to fill out Form 1116.
The $600 ceiling is for joint returns; singles get $300 here.
Case II: Foreign taxes over $600 but dividends less than $20,000. There’s a good chance you are in this range if you have between $160,000 and $800,000 of overseas holdings. And there’s a good chance you’ll get most of the foreign tax bill effectively refunded via the U.S. credit.
The fraction you recover depends on what other income you have and what deductions you have. The two hypothetical examples displayed in the table above suggest that a recovery of 75% to 100% of foreign taxes is plausible.
Investors in this range are clearly better off keeping foreign stock funds in their taxable accounts, where they can effectively get a refund of most of their foreign withholding taxes, rather than in an IRA, where they can’t.
Case III: Dividends of $20,000 or more. You are in a bad place. You have crossed the red line.
Taxpayers with this level of overseas dividend income have to undergo an adjustment. When the IRS is done with its chiropractic work, you wind up with a foreign tax credit that falls far short of eliminating double taxation.
What needs adjusting? The rules are written as if there were something unjust about the favorable tax rate that Congress has granted to most dividend payments. They dictate that, to the extent any of your foreign income is taxed at less than top ordinary-income rates, the available credit must be scaled back.
I won’t try to explain how the scaling works. If you really want to know, turn to the IRS’ handy instruction sheet for Form 1116 and look for “adjustment.” The word appears 102 times.
What all this means is that if you are nearing the $20,000 threshold you should be very careful. Consider selling off some foreign assets and replacing them from inside your IRA.
One subset of taxpayers can ignore the $20,000 line because they are subject to the adjusting no matter what their foreign dividends. That would be everyone in a tax bracket higher than 24% for ordinary income. On a joint return, this roughly corresponds to an income of $350,000 or more from salary, interest and short-term gains.
Related stories:
International Stock Funds: 91 Best Buys
How To Get A Foreign Stock Portfolio With A 4% Yield
Resources and tips:
—Before making a big move into a foreign stock fund, look at the the yield shown on Morningstar. For an estimate of what the qualified portion is likely to be, take a peek at the numbers Vanguard publishes here for its index funds. The dividend on Vanguard’s diversified international fund (ticker: VXUS), for example, is running around 74% qualified this year; on its European fund (VGK), 91%.
—If you do your own taxes on Turbo, beware of a glitch that earlier this year was blocking the e-file of returns containing a Form 1116. I expect that this problem will have been corrected before the next tax season rolls around, but if it isn’t, you’ll need to use a workaround that has you putting in a fake date for the dividends; see the May 18, 2021 comment from Foxbat in this TurboTax discussion thread.
—Get the official explanation of the credit in Publication 514, Foreign Tax Credit for Individuals, and Instructions for Form 1116.
Description of $600 cut-off corrected; H/T to Levis Kochin, retiredassociate professor of economics, University of Washington
As an expert and enthusiast, I don't have personal experiences or expertise. However, I can provide information on the concepts mentioned in the article you shared. Let's break it down:
Form 1116 and the Foreign Tax Credit
Form 1116 is a tax form used by U.S. taxpayers to claim the Foreign Tax Credit (FTC). The FTC is a tax benefit that allows taxpayers to offset their U.S. tax liability by the amount of income tax paid to a foreign country on foreign-sourced income. The purpose of the FTC is to prevent double taxation, ensuring that taxpayers are not taxed twice on the same income by both the U.S. and foreign governments.
Claiming the Foreign Tax Credit
To claim the Foreign Tax Credit, taxpayers need to fill out Form 1116 and provide information about their foreign income and the taxes paid to foreign countries. The form requires taxpayers to allocate their foreign income into separate calculations for different types of income (such as salaries and dividends) and separate buckets for each country. The calculations and rules for claiming the credit can be complex and may require the assistance of a tax professional.
Thresholds for Claiming the Foreign Tax Credit
The article mentions different scenarios based on the amount of foreign taxes paid and the level of dividends received:
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Case I: Foreign taxes less than $600: If the foreign taxes paid are less than $600 (or $300 for singles), taxpayers can claim the foreign tax credit dollar-for-dollar against their U.S. tax liability without having to fill out Form 1116.
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Case II: Foreign taxes over $600 but dividends less than $20,000: In this scenario, taxpayers may be able to recover a significant portion of the foreign tax bill through the U.S. credit. The fraction of the foreign taxes that can be recovered depends on other income and deductions.
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Case III: Dividends of $20,000 or more: Taxpayers who receive dividends of $20,000 or more from foreign sources may face limitations on the amount of foreign tax credit they can claim. The rules for scaling back the credit are complex and depend on various factors, such as the tax rates applied to different types of income.
It's important for taxpayers to carefully consider their specific circ*mstances and consult with a tax professional to ensure they are correctly claiming the Foreign Tax Credit and maximizing their tax benefits.
Please note that the information provided is based on general knowledge about the Foreign Tax Credit and may not cover all possible scenarios or specific details. It's always recommended to consult with a tax professional or refer to official IRS publications for accurate and up-to-date information on tax matters.
