Individual retirement accounts (IRAs) often include funds invested in companies subject to a foreign tax jurisdiction. In this case, a foreign government might tax your dividends or your capital gains before you ever receive them. To avoid double taxation, the IRS offers tax breaks to taxpayers who pay taxes to foreign governments.
IRS Taxation of Dividends and Capital Gains
Any dividend or capital gains income that you cannot exempt from IRS taxation using the foreign tax credit or deduction will be taxed the same as domestic income. If your IRA account is exempt from taxation until you withdraw it, it will be taxed whenever you withdraw the funds. The IRS divides dividends into two categories -- ordinary and qualified. It taxes ordinary dividends at standard income tax rates and qualified dividends at lower capital gains tax rates. To enjoy capital gains tax rates on dividends, the investor must have held the stock for more than half of the 121-day period that begins 60 days before the ex-dividend date (the ex-dividend date is the last day an investor can buy shares to qualify for a particular release of dividends). It taxes capital gains from the sale of shares at ordinary income tax rates if you held the shares for less than a year before selling them, and at capital gains tax rates if you held the shares more than a year before selling them.
The Foreign Tax Credit
If you take foreign tax credit, you may deduct the amount of foreign taxes you paid from your total total tax due, not your taxable income. You cannot claim this credit until your U.S. taxes on this income would have come due but for the credit. For an IRA account, this will probably mean that you will have to defer taking the credit until you actually withdraw the funds. To deduct foreign taxes, you must have actually paid them if you are an individual. Corporations must have paid or accrued them, depending on whether they use the cash or accrual method of accounting. Most corporations are required to use the accrual method of accounting. Tax accrues when it comes due, not when it is actually paid.
You cannot claim credit for foreign tax if you are disputing your tax bill with the foreign tax authorities. If you are overcharged by the foreign government because they failed to take into account tax advantages you enjoy due to a bilateral tax treaty between that government and the U.S., you cannot claim credit for the overcharge even if you actually pay it.
Taking the Deduction Instead
Instead of crediting foreign taxes against your total tax due, you can deduct the same amount form your taxable income. Most taxpayers choose the credit instead of the deduction because it saves more money under most circumstances. The only circumstances under which you might be better off taking the deduction is when doing so would put you into a lower tax bracket, thereby reducing your tax rate for all of your taxable income.
- IRS.gov; Ten Important Facts About Capital Gains and Losses; March 2011
- IRS.gov; Topic 404 -- Dividends; March 2011
- IRS.gov; Foreign Tax Credit - Choosing To Take Credit or Deduction; November 2010
- IRS.gov; Foreign Tax Credit - How To Figure The Credit; November 2010
- IRS.gov; Foreign Tax Credit; August 2011