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.
Form 1116
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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Tom Martin says
Harry, I agree it is confusing. I have had success, though, with Turbotax, and over the years have become pretty good at dealing with it. I much prefer the full credit rather than the default deduction!
M says
Did you not have much international stock in your taxable account, or are you going to pay a lot of capital gains to avoid this hassle? I can’t see myself wanting to do the latter.
Harry Sit says
Fortunately I don’t have large capital gains in the international fund. The recent drop in the stock market also helped me nip it in the bud.
Jon Mitchell says
TurboTax *seemed* to make the foreign tax credit relatively easy for me this year. Then again, I had no carrybacks/carryforwards, no need for schedules K-2/K-3, and no idea whether TurboTax computed the credit correctly! The most annoying part for me is having to manually adjust the “foreign” dividends, as reported on my brokerage statements, to exclude amounts that are not in fact foreign. This year, Vanguard’s 1099-DIV at least gave me the foreign source income ratio for each international fund in an appendix. It surprised me that even the Vanguard total international index (VXUS) produces dividends that are only about 90% foreign. As a NC resident, I also get a partial credit on my state return for foreign taxes paid. (Apparently most states don’t have this credit.) The combination of federal and state credits enabled me to reduce my total tax bill by about 1.5 times the amount I actually paid in foreign tax withholding (just for my taxable account investments, of course). Weird outcome, but I’ll take it.
Steve says
Hey. Talk about a timely post. I had prepared my 2021 tax return with Form 1116 on both Block and TurboTax software, but was still waiting for another form to be released on TurboTax. I had completely overlooked instructions about Schedule B of Form 1116. TurboTax had not mentioned it. Updated TT this evening, and sure enough, Schedule B is now a part of my return. I’ll have to decide next year whether trying to claim $50 of excess foreign taxes is worth filling out Form 1116 and Schedule B again.
And, if even Harry Sit is going to “quit the foreign tax credit game”, I will consider that, too. This is the first year in decades my foreign taxes required filing Form 1116. I also had to wrestle with understanding the instructions about adjusting/not adjusting entries because of income from qualified dividends and capital gains.
Thanks a lot for the post.
Andrea C says
I need your savvy even if this is two years after you posted. I use H&R Block and have to file 1116. I will need to amend 2023 to do so, so even though I filed electronically, I used the submitted H&R Block file and saved it in a play area so I could go through the ‘interview’ for the VXUS credit… (it beats trying to read the instructions and fill the paper form, at least for the first go…). BUT… their instructions regarding ‘you may have to adjust this entry’ was as vague as trying to see through mud. What I put in was the gross amount of US Dividends (but wasn’t sure how to differentiate the qualified from non-qualified parts of that). And also, since I also sold some of that stock and had some small gains of 600, wasn’t sure where to put that either… That said, it seems like only the Dividends had tax withheld…
What did you put in the gross amount field where they hinted about maybe having to adjust?
Thanks!
Andrea
Harry Sit says
See How to Enter Foreign Tax Credit Form 1116 in H&R Block.
Steve says
Couple of minor anomalies I noticed with 2021 TurboTax on Form 1116:
On Part II, (1) date paid, TT does not allow you to enter “1099 Taxes” instead of date for foreign taxes reported on Form 1099, per IRS instructions. TT requires a date.
After running final review, TT wants taxpayer to link each Form 1099 reporting foreign taxes paid to a column on Form 1116 Part I. A Form 1099-B I have has foreign taxes that are reported in three separate columns on Form 1116. I selected one column. Seems to be ok.
Bob J says
Harry, I agree that form 1116 has become too complicated. However, as I have a rental home in Canada that produces net positive income and thus Canadian tax, I need to use form 1116. I’m glad I have TurboTax. Are there any guides/tutorials that would help me get a good understanding of 1116 and its intricacies?
Harry Sit says
Sorry I don’t know. I want to stay away and not think about it.
Steve says
IRS Publication 514 is more helpful than the Form 1116 instructions. It gives examples for some situations. The Intuit/TurboTax community forum has questions and answers. Other resources I have seen online are essentially ads for tax preparers. The Form 1116 line by line help in TurboTax can be helpful, when combined with reading IRS instructions.
Mark says
Or just to make it simple, follow the John Bogle and Warren Buffett school of investing and don’t buy International funds, Mr Bogle’s logic being most US funds derive much of there income from customers outside of the US and that is all the diversity you need.
Tom Martin says
That’s not wrong, but I find holding Foreign ETF Index funds offers additional opportunities for tax-loss harvesting as they go up and down at different times than US Indexes.
Mark says
I guess that is a strategy and perhaps I’m a bit naïve but if I never had to harvest a loss I’d be fine with that. And even though the so called experts have been saying for quite a while that International funds are due to outperform US stock funds it has not happened yet at least not with the Vanguard funds I own. Total stock market compared to Total International gives an edge to The US markets. Naturally that could change, I do remember Mr Bogle saying he saw no need to invest in international funds but if you felt you must no more that 20% of your stock portfolio should be allocated to International. Personally I like to keep things as simple as possible, but everyone is different and that is a good thing.
Paul DeLeo says
The Form 1116 Schedule B was released late by IRS and their 2021 MeF schema does was not updated to allow e-filing of the data on that Schedule B. As such, every return with a Form 1116 Schedule B was going to have to be filed by mail. TurboTax engineers quickly implemented a workaround last week in which the Form 1116 Schedule B is generated as a PDF and attached to the return so that it can be e-filed.
Selena says
If the amount of foreign tax paid is slightly over $300 – do we have the option to claim only $300 credits and avoid Form 1116 or do we must report the actual exact amount and go through the form process. Thanks!
Harry Sit says
You must report the actual amount and go through the process.
Jerry says
I think this was done on purpose. My foreign tax paid was just over the $300 threshold at $318. The brokerages seem to be in cahoots with the government to get you to pay more in taxes so they report foreign tax paid as a number just big enough to require you to file the complicated Form 1116 to take the foreign tax credit but not big enough for you to be motivated to do so. I think most will opt not to and just take the double tax hit, which shouldn’t be too much.
Jerry says
I just barely went over $300 foreign tax threshold to avoid filing Form 1116 at $318. I think I’ll just skip taking the foreign tax credit just to avoid filling out that complicated form.
Steve says
Yes, Form 1116 is complicated, but in my opinion, complexity is not a reason to opt out of a potential $300 dollar reduction in someone’s income tax. The purpose of Form 1116 is to limit the foreign tax credit to no more than the percent that foreign income is of your total income. In many cases the limit is less than 10% of the total foreign tax. If you do your taxes with software, take a stab at Form 1116. See what the result is. Very unlikely that filling out Form 1116 in good faith for max credit of about $300 is going to cause IRS inquiry.
Mark H says
If you enter 299 in the software, you see that it gives you a dollar for dollar reduction of tax. So skipping the 1116 will cost you at least $300.
Jerry says
Yes, I did give it a try in TurboTax but it also triggered a lengthy alternative minimum tax section, which I never needed to do before. It just didn’t seem to be worth it.
Steve says
When Form 1116 is prepared, IRS procedures normally require an AMT version of Form 1116 to be submitted, and the AMT Form 6251. These two AMT-related forms are a normal part of Form 1116 preparation. The two forms usually have no impact on your tax return, and do not generate AMT, but get submitted as a part of Form 1116. TurboTax and Block software normally create the two forms properly.
K says
An entire article that breaks down as “I should seek a tax professional.”
Brian says
I live in the US but work overseas in the oil & gas industry. I’m accumulating more foreign tax credits than I can use since some countries’ tax rates are higher than the US tax rates.
Would it be smart to:
a) change my 401K contributions to Roth 401K
b) convert some of my 401K to my Roth 401K
to increase my US taxes so I could use more of my foreign tax credit?
Since I can’t get refunded more than what has been withheld, I’m wondering if it makes sense to increase the taxes withheld in order to fully utilize the FTC.
I realize I can roll excess FTC forward but also understand that it can only be used in a year in which I have foreign income, and eventually I’ll run out of opportunities to use it.
Harry Sit says
Changing the tax withholding alone won’t do anything. If you didn’t have enough withheld, your foreign tax credit will still reduce the amount you owe.
Switching new contributions to Roth 401k or converting existing balance to Roth 401k might help. You should do a mock tax return of last year and see what difference it makes. Make a copy of your tax file. Add a 1099-R for converting pre-tax 401k to Roth 401k. See how much additional foreign tax credit you would’ve been able to claim. See the net impact on your bottom line.
Doug says
FreeTaxUSA lets you manually enter the “foreign income”, so this allows you to manually adjust the value yourself first. A bit of a pain, but once you learn how to do the adjustment it’s not too bad, and the procedure for FreeTaxUSA looks a lot easier than what you showed in TurboTax.