How to Protect Your Foreign Dividends With Tax Credits

Man filling out his tax paperwork
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Dividend stocks are very popular in the United States because they provide investors with a steady stream of income over time. International dividend stock investment is trickier. Many countries withhold taxes from the dividends distributed by a foreign company, which can decrease the effective dividend yields. Yet there are ways to offset these charges through U.S. tax credits.

Dividend Tax Withholdings

Investing in U.S. dividend stocks is a fairly straightforward process. After receiving dividends from the stocks you own, you include them on your tax return and pay income tax. If the stocks are held in a tax-favored account, like an IRA, then you don’t pay any tax on the dividends unless you are withdrawing from the IRA.

Foreign dividend stocks are a bit more complicated. Dividends paid by a foreign corporation may be subject to tax by that corporation’s home country. In theory, this means you may have to file separate tax returns for each country in which you receive dividends. The dividend tax rates themselves also differ from country to country, so you should ask your broker for the exact rates.

Using Foreign Tax Credits

The good news is some countries have agreements with the United States to make the process a lot easier. These agreements also vary by country, so consult a tax professional before making any investments. In some cases, the U.S. Internal Revenue Service (IRS) offers tax credits to investors to offset the amounts paid to foreign tax entities.

The IRS offers either a foreign tax credit or an itemized deduction for taxes accrued in a foreign country on a foreign source of income if that income is also subject to U.S. tax. Note these tax credits are designed to prevent double taxation and can only offset taxes paid in the United States. Some retirees with incomes too low to owe taxes may not benefit.

Normally, investors receiving less than $300 in foreign tax credits can file for the credits directly on Form 1040, if the shares in question are held in a traditional brokerage account and a Form 1099-DIV was received listing the foreign taxes paid. Otherwise, it may be necessary to file Form 1116 to apply for the tax credit and attach it to Form 1040.

Finally, the foreign tax credit is not applicable in all circumstances. The credit cannot exceed foreign sources of income divided by worldwide total taxable income. And certain countries not on good terms with the United States may be ineligible for the foreign tax credit, such as countries where the United States is at war.

Retirement Account Issues

Those with retirement accounts, such as 401(k)s, IRAs and Roth IRAs, should pay special attention to these issues. With 401(k)s and IRAs, no income tax is owed in the United States on the dividends until withdrawal. Any foreign taxes withheld on dividend stocks in these accounts are lost forever. In countries where dividend taxes can be higher than 20%, this can significantly reduce effective dividend yields.

Certain countries do not withhold any taxes on dividends or offer special provisions for U.S. investors. As a result, investors with tax-advantaged accounts may want to limit their foreign dividend stock investments to these countries. Again, consult your tax professional.

Most countries have tax treaties with the United States, which may help bring down the tax rates for investors in foreign dividend stocks. But the tax rates may differ from broker to broker since each broker must file paperwork with foreign authorities.