Double taxation can occur when laws from two distinct countries require the same income to be taxed. The Foreign Tax Credit (FTC) is a non-refundable tax credit designed to alleviate this burden for U.S. citizens who earn income abroad by offsetting taxes paid to foreign governments and reducing a taxpayer’s U.S. tax liability. A financial advisor may be able to help you navigate the FTC and other tax issues.
How the Foreign Tax Credit Works
The FTC operates on a relatively straightforward formula. However, it’s not a dollar-for-dollar deduction. Rather, it depends on several factors, including your total foreign income, the foreign taxes you’ve paid and the specific source of your foreign income.
Suppose a U.S. citizen, John, earned $80,000 in total taxable income, $20,000 of which was earned in a foreign country. Applying the FTC limit formula – (20,000/80,000) multiplied by his U.S tax liability – will yield the limit of John’s FTC. Taxpayers must report these final figures on IRS Form 1116, which is submitted alongside their tax returns.
The IRS also requires foreign taxes to be “basketed” or divided into different categories based on the type of income on which they were paid. These baskets include general, passive and branch income. Taxpayers must calculate their FTC separately for each basket, and there are limitations on how much credit can be claimed for each category.
Earning income in a country with a U.S. income tax treaty could also affect the FTC limit. For example, a taxpayer who has a surge in their foreign income could potentially see their FTC limit increase, thereby providing them with a higher credit against their U.S. tax liability.
Qualifying for the Foreign Tax Credit
To qualify for the FTC, you’ll need to meet specific criteria. First, you need a foreign-source income that is taxable in the U.S. This can include income from foreign employment, business profits, dividends and interest. Additionally, you must have actually paid or accrued foreign taxes on this income.
Furthermore, you need to ensure that the foreign taxes you pay are considered legally imposed income taxes in the foreign country. Taxes that do not qualify include foreign Social Security taxes, foreign value-added taxes (VAT) and foreign taxes that you can choose to exclude or deduct. It’s essential to keep accurate records of your foreign income and tax payments to substantiate your claim for the FTC.
Qualifying for the FTC requires gathering necessary documents, filling out IRS Form 1116, and understanding the relevant tax laws.
Refundable vs. Non-Refundable Tax Credits
Tax credits come in two forms: refundable and non-refundable.
Refundable tax credits are a taxpayer’s best friend. If you qualify for a refundable credit and it exceeds your tax liability, you can receive the excess as a refund. For example, if you owe $800 in taxes but qualify for a $1,000 refundable tax credit, you could get a $200 refund. Common examples of refundable credits include the Earned Income Tax Credit (EITC) and the Child Tax Credit (which is partially refundable).
Non-refundable tax credits, like the FTC, can reduce your tax liability to zero, but you won’t receive any excess as a refund. If your tax liability is lower than the credit, you simply won’t owe any taxes.
Tax Credits vs. Tax Deductions
Tax credits and tax deductions serve the same purpose – to reduce your tax liability – but they are applied in distinct ways. Tax credits directly reduce your tax bill on a dollar-for-dollar basis. Tax deductions, on the other hand, lower your taxable income, and in turn, reduce your tax bill.
Suppose an individual can choose a $2,000 tax credit or a $2,000 tax deduction. The tax credit will reduce their tax bill by $2,000. However, the $2,000 tax deduction will reduce their taxable income, indirectly lessening their tax liability. If this person earns $100,000 per year and falls in the 24% tax bracket, their actual tax savings from the deduction would only be $480, which is considerably less when compared with the credit.
Maximizing Your Foreign Tax Credit
There are several strategies that can potentially increase your FTC. Utilizing the foreign tax credit carryback and carryover provisions to apply unused foreign tax credits to future or past tax years is one strategy.
Alternatively, claiming a deduction for foreign taxes (as part of itemized deductions on Schedule A) instead of a credit might be more beneficial depending on an individual’s tax situation.
Keep in mind that these strategies aren’t guaranteed to be universally beneficial, and personal financial circumstances can drastically impact their effectiveness.
Bottom Line
Understanding the Foreign Tax Credit (FTC), its limitations, and its qualifying criteria can play a critical role in reducing a U.S. citizen’s tax liability, paving the way for better financial decisions. Distinguishing between tax credits and tax deductions can also lead to improved financial planning, potentially resulting in significant tax savings.
Tax Planning Tips
- If you’re looking for ideas on how to potentially lower your tax liability or simply want a better understanding of how taxes impact your finances, our comprehensive tax planning guide can help.
- A financial advisor with tax expertise can be a valuable resource when it comes to tax planning. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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