Claiming Foreign Taxes: Credit or Deduction? (2024)

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.

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.

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.)

Form 1116

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.

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