Allocating part of an investment portfolio to non-U.S. stocks may be a good diversification tool, but it can also create unwelcome tax headaches. In particular, your clients may find themselves having to navigate the unfamiliar land of foreign tax withholding.
When an investor owns stocks in countries based outside the United States, either directly or through a mutual fund or ETF, it's common for the other country to withhold taxes on dividend payments from the stock. Typical withholding rates range from 15% to 25%, but can be as high as the 35% charged by Switzerland. These extra taxes can be a real drain on an investment's total return.
Before they're gripped by fears of double taxation, U.S. investors should know there are two remedies available to minimize — or even eliminate — this extra tax cost.
Foreign Tax Deduction
Just as taxpayers can deduct the income and property taxes they pay to their local state or community, they can also deduct taxes paid to a foreign country. Fortunately, foreign taxes aren't subject to the new $10,000 cap on the deduction for taxes. However, there is an exception to that exception. Taxes paid to a U.S. territory (Puerto Rico, Guam, etc.) are considered state taxes, which means they are subject to the limit.
The good news is there's an even better option for dealing with these taxes — the foreign tax credit.
Foreign Tax Credit
The more common method for recovering these taxes is to claim the foreign tax credit, or FTC. Whereas a deduction reduces the amount of income subject to tax, a credit reduces the actual tax cost itself, meaning the credit provides a greater overall benefit. The downside to the FTC? Completing the tax form needed to claim it.
Form 1116 is used to determine how much of the foreign tax paid during the year can be used as a credit against federal tax. In many cases, the full amount paid during the year is available as a credit, but not always.
This form first calculates the percentage of total taxable income that is foreign-sourced, including not just investment income but also wages or other income from overseas. That percentage is that multiplied by the total U.S. tax liability for the year to determine the amount of US tax paid on foreign income, which is the maximum FTC available for the year. If the amount of foreign tax actually paid is more than that amount, the excess credits can be carried back one year and forward up to 10 years before they expire.
To further complicate things, Form 1116 requires foreign income and taxes to be reported on a country-by-country basis. However, holders of registered investment companies, including mutual funds, can skip those details and instead lump all their information together under the country code RIC.
An exemption from filing Form 1116 is available when the only foreign income is interest and dividends, and the total foreign tax paid is less than $300 ($600 for married couples filing jointly). In that case, an FTC for the full tax paid can be claimed directly on their Form 1040 (via Schedule 3, which is new for 2018).
Another thing to consider is where the investments generating the foreign tax are held. If foreign tax is withheld from income in IRAs or other sheltered assets, no FTC is available.
Some countries will offer withholding exemptions for income paid to retirement accounts, but not all. Because of this, your clients should carefully consider whether to hold international investments in those accounts as the lack of credit for the foreign taxes makes those investments more expensive.
International investments can be an important part of a portfolio, but remember that foreign taxes increase both the complexity and the cost of holding those investments for clients.