For a variety of investors who are looking to diversify their portfolio, it can go beyond just choosing investments in a variety of industries. This can include investing in a global economy beyond the borders of the United States. However, this also means that the foreign investment income is still taxable here in the U.S., even though the funds were earned outside of the country. Additionally, those funds may also be taxable by the country where they were initially earned. Working with your tax professional or accountant, such as Precision Financial Services in Yucaipa, CA, you can determine the potential tax liability of your foreign investments. Here are a few points to assist you in understanding how these investments are taxed.
Basics of a Foreign Tax Credit
Since there is the possibility of double taxation in terms of the income that you receive from foreign investments, the U.S. tax code allows for a foreign tax credit. This credit allows you to use taxes you paid to a foreign country for investment income to be used to reduce your tax liability to the United States.
Why is this so helpful? Simply put, each country has their own individual tax laws. These laws can vary dramatically from one government to another. While some countries may have no capital gains tax or if they do, they will waive them for foreign investors. This varied type of tax treatment can also carry over into dividends and interest income as well.
You can take the time to research the tax rates prior to making an investment, but even if you do not know the tax rate, you can still take advantage the foreign tax credit. So how do you know if you paid any foreign tax? You should receive a 1k099-DIV or 1099-INT statement at the end of year. If you look at box 6, it will show any earnings that were withheld by a foreign government. It is important to take this credit because it can reduce your tax liability.
Keep in mind that if you paid more in foreign taxes than what you owe to the U.S. government, then you can only claim a credit up to the amount of tax liability that you have within the United States. However, you can also claim the whole foreign tax credit if the amount of foreign taxes paid is less than your current tax liability with the U.S. Keep in mind that you can carry over any tax credit amounts above your current year tax liability to the next year or forward up to 10 years.
Dealing with Foreign Exposure
As you can see, there is a lot of information that you will need to gather from your foreign investments on an annual basis to make sure that you meet all of your tax requirements in the United States. However, to make sure that you get that information, it can be easier to invest in a mutual fund that gives you the exposure to the global markets. Many of these mutual funds can be invested in through U.S. investment firms. As a result, you can benefit from some tax breaks using these firms, versus a Passive Foreign Investment Company (PFIC) that may result in a higher tax liability for income received from these investments.
Using foreign based mutual funds to invest means that you may have more complicated tax filings, as a result. Simply put, the U.S. tax code is not as forgiving to those who choose to make foreign investments through foreign companies. So you will want to consult with a qualified tax professional who can guide you through the process of investing outside of the country.
When it comes down to it, foreign investments can result in a solid return and be a reasonable income stream for you both now and during retirement. However, it is important to note that you will have to complete the IRS Form 1116 to determine how large a foreign tax credit you can claim, based on how much you would be taxed if you had earned that income on U.S. investments.
Information from your Form 1116 will be imputed on your 1040 filing, so you can claim the appropriate amount of your credit. Just keep in mind that the United States encourages the use of U.S. based mutual funds over foreign investments to encourage investment in American businesses. Working with a tax professional, you can determine if this credit applies to your circumstances.
