Pros and Cons of Taking a Foreign Tax Credit vs. Deduction

For U.S. citizens with foreign income, knowledge of foreign tax credits and deductions is a crucial aspect of financial planning. These mechanisms are designed to prevent double taxation, which is when someone pays both foreign and domestic taxes on the same income. There are both pros and cons of foreign tax credits vs. deductions, and understanding them is crucial for making informed financial decisions.

A financial advisor can potentially help you with tax planning decisions like using tax credits and deductions.

What Is a Foreign Tax Credit?

The IRS defines a foreign tax credit as a non-refundable tax credit for income taxes paid to a foreign country as a result of foreign income tax withholdings. So, if you have foreign income and pay or owe taxes to a foreign government, you can claim this credit to reduce your U.S. tax liability. However, the foreign tax credit is subject to certain limitations and restrictions, which we’ll discuss in detail shortly.

There are two main types of foreign tax credits: the general category and the “passive income” category. The general category encompasses taxes paid on income from a wide range of foreign sources, including wages. The passive income category applies specifically to income earned from passive activities, such as dividends, interest, rental income and royalties.

Pros of a Foreign Tax Credit

One of the most significant advantages of the foreign tax credit is that it provides a dollar-for-dollar reduction in your U.S. tax liability. If you’ve paid foreign taxes on your income, you can directly offset your U.S. tax bill with these credits, reducing your overall tax burden. For example, if John owed $10,000 in U.S. taxes and had paid $4,000 in foreign taxes, the foreign tax credit could reduce his U.S. tax bill by $4,000.

The foreign tax credit helps prevent double taxation. By claiming this credit, taxpayers can avoid this unfair burden. Additionally, the foreign tax credit is generally more versatile than the foreign tax deduction and can be applied to various types of foreign income, including passive income like dividends and interest.

Cons of a Foreign Tax Credit

Calculating the foreign tax credit can be intricate and time-consuming. To get a foreign tax credit, meticulous record-keeping and adherence to specific IRS rules are necessary. You may want to consult a tax expert when filling out forms like Form 1116, which the IRS often requires for claiming this credit.

There are also limitations on how much foreign tax credit you can claim, particularly if you have foreign income from high-tax countries. For example, the credit can’t exceed the total U.S. tax liability on foreign income. If that happens, you can carry the unused portion of the credit back for one year or forward for 10 years, after which the credit expires.

What Is a Foreign Tax Deduction?

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A foreign tax deduction allows taxpayers to deduct taxes paid to a foreign country from their taxable income. It applies to all taxes paid to a foreign country, including VAT, sales taxes and property taxes. Any U.S. taxpayer who has paid or accrued foreign taxes to a foreign country or U.S. possession can claim a foreign tax deduction. Unlike the tax credit, the tax deduction lowers a person’s overall taxable income and doesn’t directly reduce the amount of tax owed.

For example, the Foreign Earned Income Exclusion (FEIE) allows you to exclude a certain amount of foreign-earned income from your U.S. taxable income. For tax year, the maximum exclusion is $130,000 per taxpayer and $260,000 for married couples who work abroad.

Expatriates may also consider the Foreign Housing deduction or exclusion, which allows taxpayers to deduct or exclude certain housing expenses incurred while producing income and living abroad. This helps mitigate the financial burden of maintaining a residence in both the U.S. and a foreign country.

Pros of a Foreign Tax Deduction

One of the main advantages of a foreign tax deduction is its simplicity, which may appeal to taxpayers who prefer straightforward tax operations. Unlike the foreign tax credit, claiming a deduction doesn’t require a special form. It can be included as an itemized deduction on Schedule A of Form 1040 (if you itemize deductions).

Cons of a Foreign Tax Deduction

Deducting foreign taxes reduces your taxable income, but it doesn’t provide a dollar-for-dollar reduction in your tax liability. The actual tax savings might be less compared to using the foreign tax credit.

Opting for the deduction could also increase the risk of double taxation. You might still owe U.S. taxes on income that has already been taxed abroad, depending on the tax rates in both countries.

Foreign Tax Credit vs. Deduction: Which Should You Take?

The main difference between a foreign tax credit vs. deduction is the impact. A foreign tax credit directly reduces the U.S. tax you owe, while a foreign tax deduction only lowers your taxable income. For most taxpayers with significant foreign wages or investment income, the credit produces a bigger benefit because it offsets taxes dollar for dollar.

For example, say you owe $12,000 in U.S. income tax and already paid $5,000 to a foreign government. If you claim the foreign tax credit, your U.S. tax bill drops to $7,000. If you use a deduction instead, the $5,000 lowers your taxable income, but the savings might only cut your U.S. bill by $1,200 if you’re in the 24% tax bracket.

It’s important to note that you cannot claim both the credit and the deduction for the same foreign taxes in the same year. You must choose one method. The IRS does allow you to switch between the methods in different years though, so you could use the credit one year and the deduction in another, depending on which gives you the greater benefit.

The deduction may make sense if you already itemize and your foreign taxes are not substantial enough to trigger a meaningful credit. For example, someone paying $1,000 in foreign property taxes could claim them on Schedule A with mortgage interest and state taxes. In this case, the deduction adds to overall itemized savings and might be simpler than filing Form 1116 for the credit.

Ultimately, the right choice depends on your income type, tax rates abroad and whether you itemize deductions. Running the numbers—or having a tax professional compare them—will determine which option keeps more money in your pocket.

Tips for Effective Tax Planning

Tax planning requires a clear understanding of the rules that apply to your situation. Having this understanding can help you maximize credits and deductions while avoiding potential penalties.

Here are four general tips to keep in mind as you plan around foreign tax credits and deductions:

Consult a tax professional: Tax laws are complex and subject to change. Seek advice from a tax professional well-versed in international taxation to ensure you’re navigating these intricacies effectively.
Review your eligibility: Ensure you meet the requirements for each option. The foreign tax credit often is more broadly effective, but the foreign tax deduction can be more advantageous in specific situations.
Income type: Different types of income may qualify for either the foreign tax credit or foreign tax deduction. For instance, some non-income-related taxes may only be eligible for the foreign tax deduction.
Optimize deductions: If you opt for the foreign tax deduction, make sure to itemize other deductions to maximize your tax savings.

Bottom Line

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Both foreign tax credits and deductions play pivotal roles in managing your taxes if you are earning income overseas. The right choice between the two requires careful consideration and even advice from tax professionals. While a foreign tax credit enables you to reduce your U.S. tax liability on a dollar-for-dollar basis, a deduction allows you to reduce the taxable income you report to the IRS.

Tax Planning Tips

SmartAsset’s income tax calculator and tax return calculator can help you estimate how large of a tax liability you may have and how much you could stand to receive as a refund.

Consider speaking with a financial advisor with tax expertise. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with 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.