Guide to claiming the foreign tax credit on your dividend withholding

An explanation of the weird Form 1116 and how to get the most out of credit.

It’s not difficult to get credit for the taxes withheld from your overseas dividends, says Lisa Greene-Lewis, CPA at Intuit’s TurboTax. Download the 1099 electronically from your broker, then use the software’s service option to answer a few questions in plain English. This way, you don’t have to decipher the incredibly complicated IRS formulas to calculate the foreign tax credit.

Pretty good, if all you want to do is file a return and be done with it. But if you want to be a smart investor, you have to really understand what’s going on inside this software. Crucial point: If you go over a certain red line by one dollar, you suddenly lose thousands of dollars.

Foreign stocks have their attractions. They tend to be cheaper relative to earning power than US stocks and have better payouts. The average dividend yield in Europe, for example, is double the 1.3% you see in the United States. But once you venture overseas, you have tax collectors in two countries after you.

Typically, your foreign dividends will be capped for income tax withheld in the issuer’s home country. The going rate is 15%, although there are up and down variations from this point. The good news is that you can get a lot of that money back (occasionally all of it) when you file your return in the United States. But only if you play the game correctly.

The concept of tax credits is that you shouldn’t have a double tax burden when crossing a border. If you work in New York and live in New Jersey, New York will take part of your salary. When you file your New Jersey return, New Jersey gives you a credit for the tax it imposes on that salary.

Likewise, if you receive a dividend of $ 1,000 from a French pharmaceutical company, France will take away $ 150 from you. If you are in the federal 15% bracket for dividends (most dividend recipients are) and if the dividend is “eligible” (most payments from large corporations are), then you owe $ 150. federal tax. You should be able to fully credit French tax against US tax, so that there is no double duty.

Except that’s not necessarily what happens when the numbers are fed into IRS spreadsheets. The baroque rules for claiming the foreign tax credit mean you might get full credit for what you’ve already paid, or you might get only half, or you might get less than half.

The formulas require you to divide foreign income into separate calculations for different types of income (wages here, dividends there) and separate compartments for each country. They are bizarre enough to trip even the most sophisticated taxpayer.

Scott Hoppe, a CPA from San Francisco, says he had the opportunity to prepare an amended federal return for a client who was a partner in a multinational law firm with a multitude of overseas tax bills. Redoing Form 1116, Foreign Tax Credit, saved her $ 60,000.

For passive investors with no foreign income but with dividends, the rules are only a little less off-putting than they are for the legal partners of the jet set. Threshold question: Are your foreign stocks in a taxable or tax-deferred account (like an IRA)?

If the investment is inside the IRA, your tax return will be straightforward but you’ll miss it. This is because the retirement account does not cut the ice with foreign tax collectors. You are simply off the 15% withholding tax, and there is no way to credit this tax to your US tax bill.

From now on, we’ll assume you take the usual approach of putting the foreign stocks in a taxable account, taking advantage of the reduced US tax rates that apply to most dividends, and getting what you can credit.

Case I: Dividends less than $ 600. This is likely if your assets abroad are less than $ 24,000. No special effort is required. You can deduct foreign tax dollar for dollar on your obligation in the United States and you do not have to complete Form 1116.

Case II: Dividends between $ 600 and $ 20,000. There is a good chance that you are in this range if you have between $ 24,000 and $ 800,000 in assets abroad. And there’s a good chance that most of the foreign tax bill will actually be refunded through the US credit.

How much you get back depends on your other income and any deductions you have. The two hypothetical examples shown in the table above suggest that a 75% to 100% foreign tax recovery is plausible.

Investors in this line have a clear interest in keeping foreign equity 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 cannot. not.

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 must undergo an adjustment. When the IRS has finished its chiropractic work, you end up with a foreign tax credit that falls short of eliminating double taxation.

What needs to be adjusted? The rules are written as if there is something unfair about the favorable tax rate Congress has given to most dividend payments. They dictate that, to the extent that any of your foreign income is taxed at a lower rate than the highest ordinary income rate, the available credit must be reduced.

I won’t try to explain how scaling works. If you really want to know, check out the IRS’s handy instruction sheet for Form 1116 and search for “adjustment.” The word appears 102 times.

All of this means that if you are approaching the $ 20,000 threshold, you have to be very careful. Consider selling some foreign assets and replacing them from your IRA.

A subset of taxpayers may ignore the $ 20,000 line because they are subject to the adjustment regardless of their foreign dividends. It would be everyone in a tax bracket above 24% for ordinary income. On a joint return, this roughly equates to income of $ 350,000 or more from salary, interest, and short-term earnings.

Related stories:

International Equity Fund: 91 Best Buys

How to get a portfolio of foreign stocks with a 4% return

Resources and advice:

—Before you take a big step in a foreign equity fund, take a look at the performance reported on Morningstar. For an estimate of what the qualifying party is likely to be, take a look at the numbers Vanguard is posting here for its index funds. The dividend of Vanguard’s international diversified fund (ticker: VXUS), for example, is around 74% qualified this year; on its European fund (VGK), 91%.

—If you do your own taxes on Turbo, beware of an issue earlier this year that blocked the electronic returns file containing a Form 1116. I think this issue will have been fixed before the next tax season, but if not, you will need to use a workaround that will require you to enter a false date for the dividends; See Foxbat’s May 18, 2021 commentary in this TurboTax thread.

– Get the official explanation of the credit in Publication 514, Foreign Personal Tax Credit, and Instructions for Form 1116.