Wiki - Foreign tax credit - tax-deferred accounts

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Wiki - Foreign tax credit - tax-deferred accounts

Post by LadyGeek »

From: Subject: Managing my mom's account
grabiner wrote: Sat Oct 01, 2022 5:33 pm
LadyGeek wrote: Sat Oct 01, 2022 1:30 pm I don't have any experience with Foreign tax credit and will take your word for it. In any case, this is all in the tax-deferred account. It would matter when distributions are taken as taxable income.
Distributions from an IRA are not eligible for the foreign tax credit, since the income taxed by the foreign country (the dividend) was not taxed by the US, and conversely the income taxed by the US (the IRA withdrawal) was not taxed by the foreign country. The credit applies to dividends on a fund held in a taxable account. (For example, if you take an RMD from an IRA stock fund, and don't need to spend it, you can invest the distribution in a taxable stock fund. If that taxable fund is a foreign tax fund, you will get the foreign tax credit.)
I have updated the wiki article: Foreign tax credit to clarify what happens with tax-deferred accounts (tax credit does not apply). The previous version provided a brief explanation, but it was somewhat unclear to me and I missed the point.

Can the experts please review?

I got stuck on the example: Example of how it affects your taxes
Say that you hold an international stock fund. The stocks in the fund earn $1000 in dividends, but foreign countries withhold tax of $70 of those dividends. Therefore, the fund only pays you $930 in dividends; this is what you will receive if you hold the fund in a tax-advantaged account.

Now say that you hold the fund in a taxable account, you are in a 25% tax bracket, and 70% of the dividends are qualified. Your Form 1099-DIV reports $1000 in dividends, $70 in foreign tax withheld, and $700 in qualified dividends. When you do your taxes, you will owe tax on the full $1000 in dividends; 15% of the $700 qualified dividend and 25% of the $300 non-qualified dividend is $180. However, you can then take a credit for the $70 foreign tax (assuming no limitations apply), so your total tax bill is only $110. You have $820 after tax, just as if you had received the full $1000 and there had been no foreign tax withholding.
I got the $820, but I don't understand the sentence I underlined. Should the last part of the 2nd paragraph instead be worded like this?
Say that you hold an international stock fund. The stocks in the fund earn $1000 in dividends, but foreign countries withhold tax of $70 of those dividends. Therefore, the fund only pays you $930 in dividends; this is what you will receive if you hold the fund in a tax-advantaged account.

Now say that you hold the fund in a taxable account, you are in a 25% tax bracket, and 70% of the dividends are qualified. Your Form 1099-DIV reports $1000 in dividends, $70 in foreign tax withheld, and $700 in qualified dividends. When you do your taxes, you will owe tax on the full $1000 in dividends; 15% of the $700 qualified dividend and 25% of the $300 non-qualified dividend is $180. You have $820 after tax, just as if you had received the full $1000 and there had been no foreign tax withholding.

However, you can then take a credit for the $70 foreign tax (assuming no limitations apply), so your total tax bill is only $110.
I don't understand "just as if you had received the full $1000 and there had been no foreign tax withholding." because I don't see how the numbers work out to $820 as described. What am I missing?

Can an expert please provide a better explanation (or correct what's wrong)?
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livesoft
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Re: Wiki - Foreign tax credit - tax-deferred accounts

Post by livesoft »

$1,000 - $180 (the amount US tax) is $820.
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Re: Wiki - Foreign tax credit - tax-deferred accounts

Post by petulant »

LadyGeek, the comparison is to the situation as if the dividends had been US-sourced with no foreign tax withholding. In the example, this would be a qualified dividend tax rate of 15% applying to $700 and a 25% ordinary income rate applying to $300, for a total tax of $180. If foreign withholding of $70 also applied on top of this, the total impact would be $250, which would be much worse. Hence, the last sentence is correct--the foreign tax credit restored the investor to $820 after tax, just as if the $1000 dividend had been paid with no foreign tax withholding.

Here would be a suggestion:
Now say that you hold the fund in a taxable account, you are in a 25% tax bracket, and 70% of the dividends are qualified. Your Form 1099-DIV reports $1000 in dividends, $70 in foreign tax withheld, and $700 in qualified dividends. When you do your taxes, you would owe tax on the full $1000 in dividends; 15% of the $700 qualified dividend and 25% of the $300 non-qualified dividend is $180. Without the foreign tax credit, this would result in a total tax impact of $250, including $180 for U.S. taxes and $70 in foreign withholding. Next, you take the foreign tax credit, which reduces your tax liability by $70 (assuming no limitations apply), so your total U.S. tax liability would only be $110. The foreign tax credit applied here results in a total tax impact of $180, including only $110 for U.S. taxes and $70 in foreign withholding. You have $820 after tax, just as if you had received the full $1000 and there had been no foreign tax withholding.
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Re: Wiki - Foreign tax credit - tax-deferred accounts

Post by livesoft »

Another example would be a taxpayer in the 12% tax bracket with a 0% qualified dividend tax rate. So that would be $0 US Tax on $700 and 12% tax on $300 or $36. They could still get the $70 foreign tax credit if they (I think) did not have to file a Form 1116, so foreign taxes paid of less than $600 ($300). That is, they would get an over-credit.
Last edited by livesoft on Sat Oct 01, 2022 8:08 pm, edited 3 times in total.
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Re: Wiki - Foreign tax credit - tax-deferred accounts

Post by LadyGeek »

petulant wrote: Sat Oct 01, 2022 7:47 pm LadyGeek, the comparison is to the situation as if the dividends had been US-sourced with no foreign tax withholding. In the example, this would be a qualified dividend tax rate of 15% applying to $700 and a 25% ordinary income rate applying to $300, for a total tax of $180. If foreign withholding of $70 also applied on top of this, the total impact would be $250, which would be much worse. Hence, the last sentence is correct--the foreign tax credit restored the investor to $820 after tax, just as if the $1000 dividend had been paid with no foreign tax withholding.
Yes, that's what I was missing. The intent is to avoid double-taxation and the credit offsets taxes taken out by the foreign entity. Your explanation shows exactly what's going on. Now I understand. With paragraph formatting and keeping your original text, how's this look?
Now say that you hold the fund in a taxable account, you are in a 25% tax bracket, and 70% of the dividends are qualified. Your Form 1099-DIV reports $1000 in dividends, $70 in foreign tax withheld, and $700 in qualified dividends.

When you do your taxes, you would owe tax on the full $1000 in dividends; 15% of the $700 qualified dividend and 25% of the $300 non-qualified dividend is $180. Without the foreign tax credit, this would result in a total tax impact of $250, including $180 for U.S. taxes and $70 in foreign withholding.

Next, you take the foreign tax credit, which reduces your tax liability by $70 (assuming no limitations apply), so your total U.S. tax liability would only be $110. The foreign tax credit applied here results in a total tax impact of $180, including only $110 for U.S. taxes and $70 in foreign withholding.

You have $820 after tax, just as if you had received the full $1000 and there had been no foreign tax withholding.
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Re: Wiki - Foreign tax credit - tax-deferred accounts

Post by grabiner »

LadyGeek wrote: Sat Oct 01, 2022 8:05 pm With paragraph formatting and keeping your original text, how's this look?
Now say that you hold the fund in a taxable account, you are in a 25% tax bracket, and 70% of the dividends are qualified. Your Form 1099-DIV reports $1000 in dividends, $70 in foreign tax withheld, and $700 in qualified dividends.

When you do your taxes, you would owe tax on the full $1000 in dividends; 15% of the $700 qualified dividend and 25% of the $300 non-qualified dividend is $180. Without the foreign tax credit, this would result in a total tax impact of $250, including $180 for U.S. taxes and $70 in foreign withholding.

Next, you take the foreign tax credit, which reduces your tax liability by $70 (assuming no limitations apply), so your total U.S. tax liability would only be $110. The foreign tax credit applied here results in a total tax impact of $180, including only $110 for U.S. taxes and $70 in foreign withholding.

You have $820 after tax, just as if you had received the full $1000 and there had been no foreign tax withholding.
Yes, this is good and clear.
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Re: Wiki - Foreign tax credit - tax-deferred accounts

Post by petulant »

LadyGeek wrote: Sat Oct 01, 2022 8:05 pm
petulant wrote: Sat Oct 01, 2022 7:47 pm LadyGeek, the comparison is to the situation as if the dividends had been US-sourced with no foreign tax withholding. In the example, this would be a qualified dividend tax rate of 15% applying to $700 and a 25% ordinary income rate applying to $300, for a total tax of $180. If foreign withholding of $70 also applied on top of this, the total impact would be $250, which would be much worse. Hence, the last sentence is correct--the foreign tax credit restored the investor to $820 after tax, just as if the $1000 dividend had been paid with no foreign tax withholding.
Yes, that's what I was missing. The intent is to avoid double-taxation and the credit offsets taxes taken out by the foreign entity. Your explanation shows exactly what's going on. Now I understand. With paragraph formatting and keeping your original text, how's this look?
Now say that you hold the fund in a taxable account, you are in a 25% tax bracket, and 70% of the dividends are qualified. Your Form 1099-DIV reports $1000 in dividends, $70 in foreign tax withheld, and $700 in qualified dividends.

When you do your taxes, you would owe tax on the full $1000 in dividends; 15% of the $700 qualified dividend and 25% of the $300 non-qualified dividend is $180. Without the foreign tax credit, this would result in a total tax impact of $250, including $180 for U.S. taxes and $70 in foreign withholding.

Next, you take the foreign tax credit, which reduces your tax liability by $70 (assuming no limitations apply), so your total U.S. tax liability would only be $110. The foreign tax credit applied here results in a total tax impact of $180, including only $110 for U.S. taxes and $70 in foreign withholding.

You have $820 after tax, just as if you had received the full $1000 and there had been no foreign tax withholding.
That looks fine to me.
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Re: Wiki - Foreign tax credit - tax-deferred accounts

Post by LadyGeek »

Thanks! The wiki has been updated: Foreign tax credit (Example of how it affects your taxes)

In the View history tab, I gave credit to petulant for the contribution.
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