The Foreign Tax Credit

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:

How Are Investments Taxed?

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?

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