Planning for retirement can be frustrating and complicated. Individual retirement accounts (IRAs), for example, come in various forms, each with specific rules relating to taxation. On the one hand, we want to create the biggest nest egg we can through prudent saving and investment. At the same time, a bigger reserve may be hit harder by income tax levies than one that's more modest.
While the tax code has traditionally allowed for generous exemptions, its reforms have closed some of those options off. Retirees now want to know if there remains an IRA tax credit for taxes paid on overseas investments.
Traditional vs. Roth IRAs
Many IRA plans include foreign investments in their portfolios. The difference lies in how they are taxed. Traditional IRAs are sheltered from taxation until funds are distributed from the fund to the account holder. By contrast, a Roth IRA allows deposited funds to be taxed by the Internal Revenue Service (IRS), leaving distributed monies free from any such imposition.
Many factors go into why people choose one type of IRA over the other. For instance, Roth IRAs mandate no minimum distribution, so retirees can build the fund as a gift for beneficiaries of their naming. Meanwhile, traditional account holders can allow their money to grow, untouched by the government's long arm until much later.
Read More: Differences Between IRA & Non-IRA Accounts
Where Do Foreign Taxes Fit In?
Brokers and financial advisors frequently exhort their clients to diversify their holdings, not just over a variety of businesses and economic sectors in the United States. They also argue for geographic diversification, investing in institutions the world over. It must be clear, though, that such assets are not only taxed, sooner or later, by the U.S. government. The government of the foreign country in which the company is registered will also take a piece of the gains.
Are you being taxed twice? Definitely. Is that legal? In fact, it is, and some of those foreign taxes can be severe.
The good news is that you can offset this burden. Since traditional IRA contributions are tax-free, account holders can not deduct foreign levies from taxable income. However, those overseas taxes shrink the revenues earned thereby diminishing the U.S. tax liability once distributions begin.
Roth IRAs, regrettably, do not enjoy this benefit since the income they offer was already taxed ahead of time. So, there may be a deduction for foreign tax paid. This, nevertheless, is not the end of the story.
Read More: Can Foreign Tax in an IRA Be Deducted?
The IRS Foreign Tax Credit
The difference between a tax deduction and a credit might seem superficial, but there are sound accounting reasons for it. A credit is taken after taxable income, complete with all the deductions claimed, has been established. A credit is calculated against that taxable total in the interest of shrinking the overall tax liability.
The IRS itself observes more savings from taking the credit over itemizing foreign tax as a deduction. Either way, the overall amount due to both governments is lessened by deduction or reception of the credit.
Addressing Foreign Tax on an IRS Return
Form 1099 INT or Form 1099 DIV foreign tax paid is where the amount can be found. Those seeking a deduction will itemize it on Form 1040. Taxpayers desiring a credit will attach Form 1116 to 1040 before submitting the return to the IRS.
Securing financial advice that comes from experience is a wise option for IRA holders who want to minimize the losses due to a foreign government's tax rates. There are conditions and exceptions that need to be navigated very carefully.
Read More: How Does a 1099 Form Work?