Foreign Tax Credit Limitation Explained

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills
Post Reply
Topic Author
ThriftyInvestor
Posts: 10
Joined: Sun Mar 26, 2017 3:33 am

Foreign Tax Credit Limitation Explained

Post by ThriftyInvestor » Mon Jun 03, 2019 2:29 am

Foreign Tax Credit Limitation Explained - Analysis: Once Foreign Income Exceeds $20,000, Credit is Markedly Limited.

Regarding post:
viewtopic.php?t=278789

I too had a dramatic reduction in my foreign tax credit in 2018 after many years with no limitation. My only foreign income is passive dividends from foreign stock funds. In contrast to the posters above, I used a much less robust IRS “Free” File Alliance approved company than TurboTax (my returns are never free due to exceeding the income limitations, so I use the paid version.) Although advertising handling my tax situation, this less robust company's implementation had several errors, including Form 1116, for which I had to download the source documents from the IRS (Form 1116, Instructions, and Publication 514) and create my own spreadsheets to calculate the credit. I am not a tax professional, but if I have understood the incredibly complex instructions that lead to a 439 line spreadsheet, the Foreign Tax Credit can be limited by the following factors:

1.) Income taxed at standard tax bracket rates (not the lower capital gains rates)
2.) Income taxed at the lower capital gains rates
3.) Foreign qualified dividends >= $20,000
4.) Self Employment Tax
5.) Qualified Business Income Deduction

Of these five, the combination of foreign qualified dividends >= $20,000 and income taxed at the lower capital gains rates triggers the largest component of the limitation. This causes a massive reduction in form 1116 line 1a, which leads to a massive reduction in the credit as the calculations flow to lines 7, 15, 17, 19, and 21, as follows:

Instructions for line 1a, page 7-8
2017: How to make adjustment. To adjust your foreign source qualified dividends, multiply your foreign source qualified dividends in each separate category by 0.3788 if the foreign source qualified dividends are taxed at a rate of 15%, and by 0.5051 if they are taxed at a 20% rate.
2018: How to make adjustment. To adjust your foreign source qualified dividends, multiply your foreign source qualified dividends in each separate category by 0.4054 if the foreign source qualified dividends are taxed at a rate of 15%, and by 0.5405 if they are taxed at a 20% rate.

I wondered where these massive reduction factors of 0.3788, 0.5051, 0.4054, and 0.5405 come from, as the instructions give no clue. A little analysis leads to the following table:

Year
2017: 15%/0.3788 = 39.6%, the maximum marginal tax bracket
2017: 20%/0.5051 = 39.6%, the maximum marginal tax bracket
2018: 15%/0.4054 = 37.0%, the maximum marginal tax bracket
2018: 20%/0.5405 = 37.0%, the maximum marginal tax bracket

So, for 2018, investors in the 22%, 24%, 32%, or 35% tax bracket whose foreign qualified dividends exceed $20,000 can look forward to having their foreign tax credit slashed by the same proportion as an investor in the maximum 37% tax bracket. For my 24% bracket, my credit is only 1/6 to 1/4 of the foreign tax paid, depending upon how I interpret some other complex limiting factors. In 2017, my foreign qualified dividends were <$20,000 and my credit was not limited at all. Going from $19,999 to $20,000 triggers this massive reduction in the credit without any phase in. Interestingly, I downloaded the 2014 form 1116 instructions, and this $20,000 threshold triggering massive reductions in the credit was the same, seemingly not indexed to inflation, and therefore potentially affecting more taxpayers every year similar to the old AMT.

I welcome corrections from anyone who might have a better understanding of this.

SobeCane
Posts: 263
Joined: Mon Oct 25, 2010 11:13 am

Re: Foreign Tax Credit Limitation Explained

Post by SobeCane » Mon Jun 03, 2019 4:07 am

Care to share the spreadsheet you created? I

User avatar
kramer
Posts: 1732
Joined: Wed Feb 21, 2007 2:28 am
Location: Philippines

Re: Foreign Tax Credit Limitation Explained

Post by kramer » Mon Jun 03, 2019 8:31 am

Bogleheads poster Magellan had warned about this cliff a few years ago and I took careful notice at that time. Thanks for posting this here.

Personally, I normally lose around 60% of my foreign tax credit for other reasons. As a retiree not yet on Social Security, my tax rate is generally quite low, composed mostly of qualified dividends, interest/non-qualified dividends, and some Roth conversions within the 10% and 12% brackets. One can only get the foreign tax credit up to the same tax level (percentage) one pays on the rest of his income. So, for example, if you pay 5% general income tax and your foreign holdings were taxed at an average of 7%, you would lose 2/7 (about 28%) of your FTC.

It also means the marginal rate on my Roth conversions becomes lower as the FTC steadily kicks in as my regular tax bill goes up ... I think my marginal rate in the 12% bracket is actually about 9%.

Edit: I used to use Basic Turbo Tax and it was a real pain to do form 1116. I now use Premier and it's pretty seamless, well worth the money for me.

MikeG62
Posts: 2299
Joined: Tue Nov 15, 2016 3:20 pm
Location: New Jersey

Re: Foreign Tax Credit Limitation Explained

Post by MikeG62 » Mon Jun 03, 2019 8:54 am

DW and I are retired and our FTC in 2018 was only 21% of our foreign tax paid. :annoyed

Note that our foreign tax paid was >$600 so we have to grind through form 1116.
Real Knowledge Comes Only From Experience

User avatar
Rick Ferri
Posts: 8985
Joined: Mon Feb 26, 2007 11:40 am
Location: Georgetown, TX. Twitter: @Rick_Ferri
Contact:

Re: Foreign Tax Credit Limitation Explained

Post by Rick Ferri » Mon Jun 03, 2019 9:01 am

It is complicated but still worth holding foreign stocks in a taxable account because we get SOME credit. Having foreign stocks in a tax-sheltered account amounts to $0 credit. The caveat is if you pay someone else to do the calculation. Then the cost might be higher than the credit, so don't claim a credit.

Rick Ferri
The Education of an Index Investor: born in darkness, finds indexing enlightenment, overcomplicates everything, embraces simplicity.

User avatar
dodecahedron
Posts: 4912
Joined: Tue Nov 12, 2013 12:28 pm

Re: Foreign Tax Credit Limitation Explained

Post by dodecahedron » Mon Jun 03, 2019 9:21 am

Rick Ferri wrote:
Mon Jun 03, 2019 9:01 am
It is complicated but still worth holding foreign stocks in a taxable account because we get SOME credit. Having foreign stocks in a tax-sheltered account amounts to $0 credit. The caveat is if you pay someone else to do the calculation. Then the cost might be higher than the credit, so don't claim a credit.

Rick Ferri
In 2017, I had enough international equities in taxable to wind up with foreign taxes just below the $300 max credit that can be claimed without bothering with Form 1116 (for an unmarried filer). (I think my 2017 foreign tax credit was around $280.) I did not add to my foreign equity holdings in 2018 (not even via dividend reinvestment) but I wound up slightly above the $300 mark in 2018. Given the rest of my tax situation, and how busy I was, this looked like it was just not worth bothering with Form 1116 so I did not claim foreign tax credit in 2018. (I had HR Block Deluxe download, which I believe would have made it a tedious manual process to fill out the form.)

Maybe eventually out of curiosity, when I have nothing more interesting to do, I will go back and calculate my Form 1116 for 2018 and consider amending. But I doubt it. Even if you do your own taxes and don´t have to ¨pay¨ somebody else to do your taxes, it can be a pain to bother with Form 1116.

What I did do, however, was to donate enough of my appreciated international equities to my DAF that I believe will reduce my 2019 foreign taxes to under $300 so I will be able to claim a substantial credit again without bothering with Form 1116. (I was planning to donate anyway, but normally, I would have donated domestic equities because they were more appreciated.) I rebalanced by purchasing some international in my tax-advantaged.

livesoft
Posts: 69586
Joined: Thu Mar 01, 2007 8:00 pm

Re: Foreign Tax Credit Limitation Explained

Post by livesoft » Mon Jun 03, 2019 9:28 am

Anxiety about Form 1116 is mostly fear of the unknown and lack of familiarity. Once one takes the time to fill it out with tax-prep software, it is really no more difficult than filling out Schedule B or Schedule D or Form 8606 for the first time. Many of us have forgotten some of our first-time experiences with tax forms and some of the dread that probably caused. Form 1116 is no different. And that is especially true now that Bogleheads.org is here to help folks.

And the second time is a snap.

And thanks to @ThriftyInvestor for the post!
Wiki This signature message sponsored by sscritic: Learn to fish.

jebmke
Posts: 9979
Joined: Thu Apr 05, 2007 2:44 pm

Re: Foreign Tax Credit Limitation Explained

Post by jebmke » Mon Jun 03, 2019 9:33 am

livesoft wrote:
Mon Jun 03, 2019 9:28 am
Anxiety about Form 1116 is mostly fear of the unknown and lack of familiarity.
One of the "problems" with form 1116 is that it is a multi-purpose form. For many taxpayers, much of the form doesn't apply. For forms like this, the first thing I do is skim the instructions quickly, crossing out sections that clearly don't apply to me.

Then I go back and do the form by hand; often it isn't that complicated. 1116 can have an added twist inasmuch as you may need to complete your state tax return before you do this form. I generally leave it to the very end of the process.
When you discover that you are riding a dead horse, the best strategy is to dismount.

User avatar
dodecahedron
Posts: 4912
Joined: Tue Nov 12, 2013 12:28 pm

Re: Foreign Tax Credit Limitation Explained

Post by dodecahedron » Mon Jun 03, 2019 9:34 am

Rick Ferri wrote:
Mon Jun 03, 2019 9:01 am
It is complicated but still worth holding foreign stocks in a taxable account because we get SOME credit. Having foreign stocks in a tax-sheltered account amounts to $0 credit. The caveat is if you pay someone else to do the calculation. Then the cost might be higher than the credit, so don't claim a credit.

Rick Ferri
Another reason to avoid holding international in taxable is that foreign stocks have a higher dividend yield (VTI yield is 1.99% while VXUS yield is 3.04%), which means more dividend drag. This is particularly an issue for folks who need to worry about AGI due to MAGI cliff effects (e.g., IRMAA, ACA, cutoffs for senior citizen property tax benefits) or issues with investment income (kiddie tax, limits on investment income for EITC).

User avatar
dodecahedron
Posts: 4912
Joined: Tue Nov 12, 2013 12:28 pm

Re: Foreign Tax Credit Limitation Explained

Post by dodecahedron » Mon Jun 03, 2019 9:43 am

livesoft wrote:
Mon Jun 03, 2019 9:28 am
Anxiety about Form 1116 is mostly fear of the unknown and lack of familiarity. Once one takes the time to fill it out with tax-prep software, it is really no more difficult than filling out Schedule B or Schedule D or Form 8606 for the first time. Many of us have forgotten some of our first-time experiences with tax forms and some of the dread that probably caused. Form 1116 is no different. And that is especially true now that Bogleheads.org is here to help folks.

And the second time is a snap.
I don´t expect there will be a ¨second time¨ for me due to my donation of international equities.

That said, while I was way too busy with other stuff in early April of this year to bother with Form 1116 (and had enough other credits available that it did not change this year´s bottom line), I might consider doing a pro forma 1116 just for curiosity and the learning experience about another crazy convoluted part of our tax system.

If I were to actually *file* an amendment with a Form 1116 to claim the credit on 2018, it would not actually a generate a cash refund for me but it might increase the amount of my carryover solar investment credit available for next year. I suspect the amount will be quite small (possibly zero).

User avatar
kramer
Posts: 1732
Joined: Wed Feb 21, 2007 2:28 am
Location: Philippines

Re: Foreign Tax Credit Limitation Explained

Post by kramer » Mon Jun 03, 2019 10:04 am

Don't forget that you can look back one year for the foreign tax credit (besides carry forward 10 years).

In my first full year of early retirement, I paid zero income taxes (all my income above the standard deduction was capital gains and qualified dividends). However, I ended up getting a four figure refund on the foreign taxes I paid that year on mutual funds because I was able to carry them back to my final working year when my tax rate was plenty high to allow more foreign tax credit. I just had to file a tax amendment for the previous year.

I suspect there are many people who miss out on this free money.

User avatar
dodecahedron
Posts: 4912
Joined: Tue Nov 12, 2013 12:28 pm

Re: Foreign Tax Credit Limitation Explained

Post by dodecahedron » Mon Jun 03, 2019 11:53 am

ThriftyInvestor wrote:
Mon Jun 03, 2019 2:29 am
the Foreign Tax Credit can be limited by the following factors:

1.) Income taxed at standard tax bracket rates (not the lower capital gains rates)
2.) Income taxed at the lower capital gains rates
3.) Foreign qualified dividends >= $20,000
4.) Self Employment Tax
5.) Qualified Business Income Deduction
Curious as to whether those with experience and intuition can predict how these things would have worked out for me if I had done a Form 1116.

Items #3,4, and 5 above do not apply to me.

In 2018, I had large itemized deductions relative to my income (mostly charitable donations, but also $10K* in SALT and significant medical deductions) and very little of #1 above, all of which was taxed at 10%. The lion´s share of my taxable income was in #2, qualified dividends, all of which was taxed at zero percent. (Ultimately the bottom line on the whole 1040 was zero due to my solar tax credit carryforward.)

My 1099-DIV lists foreign div income of $4,633 and foreign taxes paid of $345.

My instinct/intuition** was that filling out a Form 1116 would have given me a foreign tax credit of zero (or possibly a bit more due to some quirk that I am not familiar with.)

*If it matters, all of my SALT was real estate tax and sales tax. I did not claim state income tax as part of my SALT deduction.

**To the extent I have any instinct/intuition for this, it is due to my experience with the somewhat analogous (??) state tax credits that state residents are allowed to claim on their resident state income tax returns if they paid nonresident state income tax to another state.

Edited to add:
kramer wrote:
Mon Jun 03, 2019 10:04 am
Don't forget that you can look back one year for the foreign tax credit (besides carry forward 10 years).

In my first full year of early retirement, I paid zero income taxes (all my income above the standard deduction was capital gains and qualified dividends). However, I ended up getting a four figure refund on the foreign taxes I paid that year on mutual funds because I was able to carry them back to my final working year when my tax rate was plenty high to allow more foreign tax credit. I just had to file a tax amendment for the previous year.

I suspect there are many people who miss out on this free money.
I don´t think this would help in my case. I had no federal income liability in 2017, so the one year carryback won´t help. The ten year carryforward also seems unlikely to help and I am hoping to keep my foreign tax paid below $300 going forward to eliminate need for Form 1116 in the future.

Topic Author
ThriftyInvestor
Posts: 10
Joined: Sun Mar 26, 2017 3:33 am

Re: Foreign Tax Credit Limitation Explained

Post by ThriftyInvestor » Wed Jun 05, 2019 2:18 am

SobeCane wrote:
Mon Jun 03, 2019 4:07 am
Care to share the spreadsheet you created?
jebmke wrote:
Mon Jun 03, 2019 9:33 am
One of the "problems" with form 1116 is that it is a multi-purpose form. For many taxpayers, much of the form doesn't apply. For forms like this, the first thing I do is skim the instructions quickly, crossing out sections that clearly don't apply to me.
Unfortunately, I did not set out to create an all-encompassing spreadsheet. All I did was copied and pasted Form 1116 and associated worksheets and instructions into a spreadsheet, then inserted a column to the left to enter data or formulas. Like jebmke, I only copied and pasted the portions that apply to me (which took the better part of half a day, mostly to read the instructions to figure out what DID apply to me), so unfortunately the spreadsheet would unlikely be of use to another taxpayer, or worse, misleading, possibly omitting portions that apply to others. It will be a great day when the IRS shares its spreadsheets with the rest of us so no one needs to create their own.

Post Reply