It’s tax season – everyone’s favorite time of year.

Because U.S. tax law is so complex, there are thousands, if not millions of credits that go unclaimed every year.

[ad#Google Adsense 336×280-IA]For example, if you bought a private airplane that you use to fly to visit your investments, you likely can deduct your airplane expenses from your investment income.

Or if you use alternative medicine such as herbs or acupuncture, those expenses may be deductible.

A more common credit that people take is the foreign withholding tax credit. But what they may not know is that by holding foreign investments in the wrong account, they may lose that credit.

Breaking It Down

When you own stock of a company based in a foreign country, you often have to pay taxes to the government of that country if you collect a dividend or capital gain. For U.S. investors, the rate is dependent on tax treaties that each country signs with the United States. If you pay the foreign tax, the IRS will give you a credit.

Here’s how it works.

Let’s say you own 100 shares of a company based in Canada that pays a $1 per share dividend. The Canadian government collects a 15% tax on those dividends. You would not owe the Canadian government the money. They’d take it right off the top of your dividends, so you’d receive $85 instead of $100.

When you file your U.S. tax return, you’d receive a $15 credit for the money you paid to the Canadian government. But more on this in a moment.

Now let’s assume you also collected $200 in dividends on U.S. stocks throughout the year. The standard tax rate on dividends is 15%, so you’d owe $30 in taxes on those U.S. dividends. Your Canadian dividends would also be subject to the U.S. tax of 15% or $15.

However, because you’ve already paid $15 to the Canadian government, you would receive a tax credit of $15. So instead of owing $45 to Uncle Sam, you’d now owe $30.

Since you’ve already paid the Canadian government, you’re still paying a total of $45, which is 15% of the $300 total. But you don’t have to pay the U.S. another $15 on top of the $15 that Canada already took.

Every country has its own negotiated rate with the U.S. For example, Taiwan charges 20%, while Singapore doesn’t take any taxes off the dividend.

Retirement Accounts

When you hold the foreign stock in a retirement account such as an IRA or 401(k), the rules are different. In those cases, the foreign government will still take its share before you get your dividend. But – and this is important – you cannot claim the tax credit from the IRS. So the money is gone.

In the above example, if the two stocks were held in a traditional IRA, the dividends on the U.S. stock would be tax deferred, however the Canadian government would still take the $15 off of your dividends and there would be no way for you to get it back. The IRS would not give you a credit and the Canadian government wouldn’t give a loonie’s patootie that the stock is in a U.S. retirement account.

That doesn’t automatically mean that you never put a foreign stock in your retirement account. You need to consider if the country will tax you on capital gains and how it will impact your taxable income.

For example, it may be worth sacrificing a portion of your foreign dividend by keeping it in an IRA if the dividend in your taxable account will push your taxable income into another tax bracket (or if the expected tax-deferred capital gain on the stock is worth giving up some of your dividend).

As I always suggest, when it comes to taxes, speak with a tax professional.

But at the very least you should be aware that if you have foreign stocks in your retirement accounts, you may be losing a portion of your dividend that you don’t need to.

Good investing,

Marc

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Source: Wealthy Retirement