When a mutual fund or ETF invests in international stocks, some foreign governments tax the fund on its income. The taxes paid to foreign governments lower the fund’s return. If you have the fund in an IRA, there’s no way to recover those taxes. You just have to live with the lower return.
However, if you have the international stock fund in a regular taxable account, the U.S. government lets you claim a foreign tax credit on the taxes paid to foreign governments. Because this lowers your taxes, it favors keeping the international stock fund in a regular taxable account as opposed to in an IRA.
Dividend Yield and Qualified Dividend Ratio
The foreign tax credit isn’t the only factor though. International stock funds tend to pay out a higher dividend. A higher percentage of their dividends also tends to be non-qualified, which are taxed at a higher rate than qualified dividends.
For example, Vanguard Total Stock Index Fund, which invests in U.S. stocks, paid out 1.3% as dividends last year and 95% of its dividends were qualified. Vanguard Total International Stock Index Fund paid out 3.2% last year and only 65% of its dividends were qualified. Both the higher dividend payout and the lower percentage of qualified dividends raise your taxes when you hold an international stock fund in a regular taxable account.
In addition, the higher dividends raise your AGI, which can have ripple effects on ACA health insurance subsidy, Net Investment Income Tax, tax on Social Security, Medicare IRMAA, and many other areas that key off the AGI.
How do you balance the two factors going in opposite directions? If you invest in both a U.S. stocks fund and an international stock fund and you have both IRAs and taxable accounts, which fund should you put in your IRA, and which fund should you put in a taxable account?
A Wash in the Grand Scheme
Leif Dahleen at Physician On FIRE calculated with different funds in different tax brackets. Sometimes you’re better off holding international funds in an IRA, and sometimes you’re better off holding them in a taxable account. The absolute differences are close either way. I would call them a wash in the grand scheme.
Other practical considerations play a role when it’s more or less a wash dollar-wise.
Claiming the foreign tax credit is as simple as putting a number on your tax return when you paid only a small amount of foreign taxes. The IRS sets that threshold at $300 for single filers and $600 for married filing jointly. When you paid more than $300/$600 in foreign taxes, the IRS doesn’t give the credit as easily. You have to file Form 1116 with your tax return.
The whole purpose of Form 1116 is to see whether your foreign tax credit should be less than the full amount of the foreign taxes you paid. The two-page form comes with 24 pages of instructions. Dividends from a mutual fund that invests in international stocks get lumped with wages, rental real estate, and mortgages in foreign countries.
Adjust Foreign Income
Form 1116 asks for your foreign-source income to see whether your foreign tax credit should be limited. H&R Block tax software has this seemingly innocent note when you enter the foreign-source income:
You might need to adjust this amount if it includes foreign capital gains or qualified dividends. To learn more, see the Form 1116 instructions, under Foreign Qualified Dividends and Capital Gains (Losses).
Because a portion of the dividend from your international stock fund is qualified dividend, they want you to read the 24-page Form 1116 instructions to learn how to adjust the income and give the already adjusted amount. If you actually attempt to read the instructions, you’ll see confusing adjustment procedures such as dividing your dividends into different buckets and multiplying them by 0, 0.4054, and 0.5405 respectively. Good luck with that!
You may not realize there’s an adjustment exception that you may qualify for. If you qualify for the adjustment exception, you can do it correctly in H&R Block software only if you follow How to Enter Foreign Tax Credit Form 1116 in H&R Block. I daresay the majority of Form 1116’s filed using H&R Block software are wrong because users don’t realize what that fine-print note means and they don’t activate the adjustment exception available only in the Forms mode.
Some other software such as FreeTaxUSA doesn’t adjust the foreign income, period. It produces a wrong tax return when you don’t qualify for the adjustment exception.
Carryover on Schedule B
The IRS added a new Schedule B for Form 1116 to track the portion of foreign tax credit that you can’t claim in full. You carry the residual amount to the following year and try your luck again.
H&R Block tax software says this if you can’t claim 100% of your foreign taxes paid:
If you’re claiming a carryback or carryover, you can’t e-file.
Go to www.irs.gov and download a copy of Schedule B (Form 116) Foreign Tax Carryover Reconciliation Schedule. Complete the form and enter the sum of any carryover of foreign taxes from Schedule B (Form 1116) Foreign Tax Carryover Reconciliation Schedule, line 3, column (xiv) plus any carrybacks to the current tax year.
Attach a copy of Form 1116 Sch B to your paper-filed return. To learn more, see the Form 1116 instructions for Part III – Figuring the Credit.
They ask you to download the form from the IRS website, complete it yourself, and attach it to your printed tax return. Oh boy. I thought the purpose of using tax software is to avoid having to fill out tax forms by hand.
Quit the Game
Subjecting myself to the torture to see whether I can claim only 93% of the foreign taxes paid this year is totally not worth it to me. Even if it turns out you can claim 100%, you still have to go through the exercise.
I decided to quit this game in the spirit of making fewer things matter. I sold the international fund in my taxable account to buy a U.S. stock fund and I did the opposite in my IRA. I won’t have to worry about dealing with the foreign tax credit next year.
If you still want the foreign tax credit, try to limit your foreign taxes paid under the IRS threshold of $300 single and $600 married filing jointly. Or use TurboTax, which does a better job of handling Form 1116. See How to Enter Foreign Tax Credit Form 1116 in TurboTax for a walkthrough.
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