By Dr. Jim Dahle, WCI Founder
Many sophisticated investors know that there is a foreign tax credit that reduces your US federal income tax bill because you (or more likely your mutual funds in a taxable account) paid taxes to foreign governments. This is often a reason given to move international stock mutual funds into your taxable account before US stock mutual funds.
“You lose the foreign tax credit if you put international in your IRA.”
Well, that much is true, although its effect on tax efficiency these days is probably more than offset by the higher yield available with international stocks compared to US stocks. However, I think many people have, like me until very recently, a misunderstanding of how the foreign tax credit works. I assumed it worked like most state tax credits. If I pay tax to the state of California for California-sourced income, I get a credit for that on my Utah state taxes. Essentially, I don't pay any tax on that income to Utah. I mistakenly assumed that was how the foreign tax credit worked. Pay $1,000 in foreign taxes, and reduce your US tax bill by $1,000.
Sometimes that's how it works. But not always. There is actually a very complex calculation done on IRS Form 1116. Your foreign tax credit then flows from Form 1116 Line 35 to Form 1040 Schedule 3 Line 1 to Form 1040 Line 20, where it is subtracted from the tax you owe to the US.
I Didn't Get the Foreign Tax Credit in 2022
I originally tried to write this post in 2023. But when I looked at my 2022 tax returns for an example, I discovered that I didn't actually get a foreign tax credit that year. This is despite ALL of our foreign stocks being in a taxable account. We received substantial dividends from those funds and paid a low five figures in foreign taxes during 2022 via those funds. So, I was expecting an equally substantial foreign tax credit. Imagine my surprise as I reviewed the work of our tax preparer to discover that for 2022, I did not have a foreign tax credit at all.
Then, as I looked back at the last couple of years of tax returns (2020 and 2021), I realized that my foreign tax credit was not as large as I expected for either of those years. Either my old tax preparer was doing things all wrong, or this thing does not work the way I thought it did. It got so convoluted that I actually put off publishing this post for a couple of years afterward. Mostly because I wanted to see how my new tax preparer did this form.
Fast forward to early 2025, when I now have my 2023 tax return completed and even have my 1099 for 2024. The good news is that I eventually got that credit I was expecting back in 2022. No harm, no foul, I suppose. But you may find yourself in a similar situation thanks to the complexity of the calculations on Form 1116.
More information here:
Why So Many Non-Qualified Dividends? Let’s Look Through My Tax Info to Figure It Out
Tracing the Credit
Let's work our way through the tax forms. First stop? Form 1040.
As you can see, the number on that line comes from Schedule 3. Let's look at that next.
The foreign tax credit is on Line 1 and totals up to Line 8, which transfers to Form 1040. Line 1 says to attach Form 1116 if required. I guess we'd better read the instructions to find out if it is required and, if not, what to put on that line. The instructions for Form 1040 Schedule 3, Line 1 read as follows:
A careful reading of those instructions reveals the following for most mutual fund investors: if you have paid less than $300 ($600 married) in foreign income taxes, you can skip Form 1116 and just put the amount you paid on this line, so long as that's not more than you owe in tax. It's a non-refundable credit, after all. Everyone else has to do Form 1116.
What does Form 1116 look like? It's a two-page form, although the instructions are 26 pages long. In those instructions, you learn that you could actually claim foreign income taxes paid as an itemized deduction on Schedule A (Line 6), but since most of us are already deducting the maximum $10,000 there, that's probably not a great idea. But be aware that it is an option to take a deduction instead of the foreign tax credit.
Form 1116 starts like this:
Not much up there. We're just filling this out for mutual fund investors, not someone who actually worked overseas or owns a bunch of small businesses overseas. Check Box C. Next is Part I.
Seems complicated already, no? You've got to fill out one column for every country? What if you're invested in a total international stock market fund? That's a lot of countries. Surely you don't need a dozen of these forms, do you? I think it's fine to put “various” on Line 1A, just like your Vanguard Consolidated 1099 shows.
The IRS is OK with that, per the instructions:
Now, you would think you can just put the total of your foreign dividend income from the consolidated 1099 onto Line 1a of 1116. But this is where things get really interesting, particularly for high earners. Basically, you find out that to determine what goes on Line 1a, you've got to go to either the Qualified Dividend and Capital Gain Tax Worksheet in the Form 1040 instructions or, more likely, Schedule D and the tax worksheet in the Schedule D instructions. You're going to have the number going on Line 1a limited by a calculation. Despite paying all of those foreign taxes, you may not be able to claim them all as a credit. While I'm sure tax software takes care of this automatically, it's all due to a little paragraph on Page 9 of the Form 1116 instructions:
In our case, we make too much (more than $182,100 single or $364,200 married for 2022 although you have to do an entire worksheet to calculate the income they care about) to qualify for one of the exceptions to this calculation. Since we're in the 20% qualified dividend bracket, our foreign income is multiplied by 0.5405.
Part II is pretty straightforward for mutual fund investors. You're just checking Box J, filling out Line A with “various “under L and the taxes paid on your dividends (Line 7 on my consolidated 1099) in Column Q, and totaled up in Column U. On to Part III.
Oooh. There's a lot there. Thankfully, I don't have to figure it all out anymore since I gave up doing my own taxes when I could no longer figure out which state tax returns my private real estate fund income required me to file. Let's just take a look at my 2023 Form 1116. In an attempt to keep my kids from being kidnapped, I'll black out a few parts of this form.
Only one thing to note here. Our mortgage is paid off. Just kidding. But if yours isn't, this section will have more lines filled out on it.
Our only real thing to fill out in this section is our HSA contribution. The real thing I want you to notice is that Line 1a looks REALLY simple, right? It's not. You're at the bottom of Page 11 of the instructions before you get to the instructions for Line 1a. And the instructions for Line 1b are on Page 17. That's right, 16 of the 26 pages of the instructions are pretty much about Line 1a. I'm not even sure many tax preparers know how to fill Form 1116 out correctly. I look at my 2023 Line 3b, and it's dramatically smaller than my 2022 Line 3b. I can't find the “statement” the 2o22 tax preparer was supposed to include with Line 3b on my tax return. At any rate, the 2022 preparer included a lot more deductions than the 2023 preparer, resulting in our having to carry over our 2022 foreign tax credit to 2023. Good luck if you're doing your own taxes. Here are the Line 3b instructions:
I'm really not 100% sure which preparer messed this up, but there's no way they both did it correctly. I'm guessing the 2022 preparer didn't get it right, given that she fired me for having too complex a return. I suspect she incorrectly (I think) included either our 199A deduction or our charity deduction on that line.
Moving on to the next section. Thankfully, this one is way more straightforward.
Easy peasy, right? The Vanguard consolidated 1099 shows $9,436 in foreign taxes paid, and my 1116 shows $9,436 in foreign taxes paid.
Let's move on to Part III.
Lots more calculations here, but the bottom line is this: in 2023, we not only got our 2023 foreign tax credit but another $12,688 we'd been carrying forward from the prior years. Given all of these calculations, it is entirely possible you will not get the foreign tax credit you are expecting, especially if you mess anything up in the calculations.
What Should I Expect in 2024?
As I write this, I just received my 2024 Vanguard Consolidated 1099.
Looks to me like we've got an $11,144 credit coming this year. But I'm not going to count my chickens until the preparer goes through Parts I and III of Form 1116.
More information here:
What You Need to Know About the Foreign Tax Credit
As a general rule, if you pay foreign taxes via your mutual funds, you'll probably get a credit for them on your taxes. If you pay less than $300 ($600 MFJ), it's a lot more straightforward than if you pay more, because you can avoid Form 1116 entirely. And it appears that not all tax preparers know how to fill it out correctly. Due to the complexity of the calculation, it's possible you won't get your tax credit in any given year, but it should be carried forward until you can use it. If you are filling out Form 1116 yourself, pay particular attention to Line 3b.
What do you think? Have you ever not qualified to take a foreign tax credit you expected to be able to take? What happened?
So right now my credit is like $20. So I need to 30x my investment to get anywhere close to fill out 1116?
That’s right.
After reading this, my only comment is that our tax system is ridiculously byzantine. If professional tax preparers can’t get this right, maybe it is just too complicated and needs to change. Flat tax anyone?
As a high earner/high tax payer, I’d be a big fan of a flat tax. I like it for intellectual reasons too. And it certainly would be simpler. People might be surprised how low it is if you got rid of all the deductions too.
In a limited way we can understand the FTC as follows.
Foreign dividends are designated Qualified Dividends for U. S. federal tax purposes; regardless how high one’s income, those foreign dividends receive preferential U.S. tax treatment until the FTC takes some or all of the so-far in-the-tax-calculation tax preference back for higher incomes. See the Qualified Dividends and Capital Gains Tax Worksheet, which is the tax calculation page for all such incomes. Up to a limit, all lower incomes have some of the Qualified Dividends and Capital Gains taxed at 0%, then with rising lower income taxed at 10%, followed by 15% and 20%.
Note that those whose Qualified Dividends and Capital Gains income tax stops at 15%, receive no U,S, tax break on such foreign dividend income. It follows that there is no need to reclaim any tax break via Form 1116 on such foreign income because there was none. Lower incomes get back all withheld foreign taxes via Form 1116, or by the $300/$600 exemption noted in the WCI’s blog.
Once into the 20% rate and beyond, Form 1116 becomes enormously complex, making any effort to explain hazardous, if what precedes is not also impenetrable..
Pretty crazy how complicated it is huh?
Good explanation for a complicated topic. A few comments:
1. I suspect that line 3a should not be blank (if this is not the AMT form) and would at least report your standard deduction if you do not itemize and the $10,000 SALT limitation for your Utah state taxes if you did itemize. I write that because your first image shows the regular form 1116 and not the AMT version where this line might be blank. If your screen shot is from the AMT version it may be worth mentioning that because the IRS guidance you quote is not for the AMT version’s 3a.
2. What is a little odd to me about your 1116 is that identical amounts are reported twice in columns A and C. Usually one would have all of the foreign dividends and taxes from one custodian (in fact, even combined from several custodians) in one column in Part I especially because you are not trying to report individual countries separately or give the exact dates that dividends were received (e.g. you take the usual shortcut of giving 12/31/23 as the date paid on Part II even though these will have been quarterly distributions with countless individual dates of foreign taxes paid which your mutual fund custodian never discloses). Because you write “Vanguard consolidated 1099 shows $9,436 in foreign taxes paid” which matches the total from adding the columns I am assuming there isn’t an accidental duplication here but that is another way this might happen.
3. It is also odd that your line 3d for gross foreign source income is 60,208 instead of 83,626. This should be the total foreign income for this income category as the instructions are:
“Line 3d. Enter your gross foreign source income from the
category you checked above Part I of this Form 1116. Include
any foreign earned income you have excluded on Form 2555
but don’t include any other exempt income.”
4. As mentioned above, if you are subject to the AMT you will have prepared 2 Forms 1116 (regular and AMT) for passive income and it is common for the AMT version of 1116 to reduce the credit further.
PharmMedMD ,
I was reading this today and agree with some of your thoughts and thought I would write my own in response.
1. I concur with you and I also put the standard deduction in box 3aA. I have done my own taxes in Turbotax the past 2 years and I believe they automatically put the standard deduction in that box, and my CPA did in the past. I don’t have an HSA anymore to put in the line 3b, like Jim did, but I think that Turbotax automatically puts HSA there, along with the one half self-employed payroll tax deduction and the Self Employed Health Insurance Premium Deduction. I remove those last two on the worksheet after finding some information online with The Finance Buff website. Turbotax wants to put it in there and I had asked my accountant a few years ago why he didn’t show anything there, and Turbotax did. He said he didn’t know exactly why and said he had a very expensive tax program that did it automatically. He said he could look it up for me but then he would have to charge me an hourly research fee and I didn’t think it was worth it since his name was on the form at the preparer back then. I eventually found information on both The Finance Buff site and I think the Turbotax site to back those two items out. His program may have done all that behind the scenes.
2. I also see the two columns posted as being some type of error, most likely. My form shows everything entered in column A, and then again under the Total column. B and C are empty.
3. The last two years (2023 and 2024) I personally did my return by myself and I show a smaller amount in 1a than I have in 3d. The reason is because of the adjustment that gets done on the worksheet based on qualified and non-qualified dividends that have to be split over line 1g and 1h. I also found that on the two previous tax returns that my CPA completed however, on the two years prior to those he had the identical amount in both fields. Why the difference? I don’t know, maybe it had to do with carryovers or maybe he didn’t split the qualified non-qualified and just did them all as one? As others have noted, this is a complicated form and I don’t think that many people really know how to fill it out perfectly, including the IRS and CPA’s. It took me working with it for about five tax returns to really get a handle on it. Last year went pretty smooth in working with the form as I finally understood what the program was doing and what I needed to manually adjust. I use a spreadsheet to split out the Foreign Taxes, foreign qualified dividends and foreign non-qualified dividends so I can complete the form properly. At least I hope I did it properly.
Just my thoughts for what it’s worth.
I am not sure if you think this still holds true, but I switched my taxable holdings to US stocks and instead placed my international stocks in my Roth IRA based on this article by PoF back when I read his stuff before the change in ownership.
https://www.physicianonfire.com/international-stock/
As long as the switch didn’t cost anything capital gains tax wise, I think it’s probably the right move. If it’s not, it’s probably not wrong by much.
Does the FTC always pertain to Int’l Mutual funds or stocks or can there be any other sources of income to get the FTC outside the country like business interests or having interest bearing bank accounts outside the US?
Yes, any foreign taxes you pay can qualify for the foreign income tax credit.
If someone had 18,000 listed on form 1116 as income from a foreign source as it says OC, how much of an intl stock index fund would one have to own
I guess someone can have income other than funds like bank accounts or other investments OC
Doing research for my daughters divorce and my education
Maybe try dividing by the yield of the fund to get an idea.
think its not intl funds as the position he has is minimal