International investments bring a unique twist — foreign taxes

U.S. investors have two ways to minimize — or even eliminate — the hit from the taxes withheld by other countries

Jan 17, 2019 @ 3:51 pm

By Tim Steffen

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.

(More: Vanguard recommends investors increase non-U.S. holdings to 40%)

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.

(More: Tax break for business owners at risk as shutdown drags on)

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.

(More: Variety of tax benefits help offset the cost of college)

Tim Steffen is director of advanced Planning for Baird. Follow him on Twitter @TimSteffenCPA.


What do you think?

View comments

Upcoming event

Nov 20


Future of Financial Advice

An innovative conference dedicated to improving the client experience by enhancing digital technology, mainstreaming healthcare and optimizing wealth management strategies.The Future of Financial Advice will provide a forum for... Learn more

Most watched


Schwab's Jeff Kleintop: Prep for volatility given China trade uncertainties

China could be considered a developed market in five to seven years , according to Jeff Kleintop, chief global investment strategist, Charles Schwab.


Young advisers envision a radically different business in five years

Fintech and sustainable investing are two factors being watched closely by some of the 2019 class of InvestmentNews' 40 Under 40.

Latest news & opinion

TIAA exits the life insurance business

The move is a big deal for RIAs, experts say, since TIAA was one of only a few insurers to offer fee-only life policies.

Advisers step up efforts to help clients manage student loan debt

As some Democrats campaign to wipe the slate clean, financial planners focus on limiting the amount students borrow.

Funding for Reg BI, other SEC advice reform efforts denied in Waters amendment

House likely to approve measure that effectively kills rule package, but it faces uphill battle in Senate

Wall Street lashes out at Sanders' plan to pay off student debt with a securities trading tax

Financial pros argue that a transaction levy will hurt mom-and-pop investors along with investment houses.

GPB paid B-Ds and reps steep commissions to sell troubled private placements

GPB paid commissions of 9.3%, or $167 million altogether, on the firm's private placements.


Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.


Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print