As you consider broadening your financial portfolio, you may be interested in foreign investments. But, before you begin, there are some things you should be aware of — such as the foreign tax credit and other tax implications.
- Why you may want to invest outside the United States
- To diversify your portfolio
- To take advantage of rapidly growing parts of the world
Why you may want to invest outside the United States
Depending on the type of investments you choose with foreign investing, you may need to deal with the foreign tax credit or other complex tax situations when you file.
Investing in the United States might be a good entry point when you first start investing, but it isn't the only place available to you. There are a few different reasons why you might consider investing outside the United States.
To diversify your portfolio
The world is a big place. While the United States may be one of the world's largest economies, it isn't the only one. Rather than invest only in companies in a single country, you can diversify your portfolio by investing around the world, too.
- Diversifying your portfolio to include companies in other parts of the world can help during times when the U.S. economy may be faltering but other parts of the world are still growing.
- The opposite is also true. If companies in other countries that you've invested in begin declining while the United States is growing, your returns may not be as strong.
Even so, a properly diversified portfolio can give you an appropriate amount of exposure to help balance your portfolio's returns when companies throughout the world have different returns.
To take advantage of rapidly growing parts of the world
Economies in different parts of the world grow at different rates. At any given time, there may be countries that are going through a growth spurt, which could result in those companies experiencing rapid growth. If you only invest in the United States, you may miss out on these opportunities.
How the foreign tax credit may be able to help
If you invest in foreign countries, you may be at a slight tax disadvantage, as other countries may tax the investments based in their region. Due to the income tax system in the United States, you would also have to pay U.S. income taxes on those investments.
Fortunately, a tax credit may offer some relief.
What is the foreign tax credit?
The foreign tax credit can offer taxpayers relief from double-taxation in certain cases where a foreign government taxes income that would also be taxed in the United States. The amount that qualifies for the tax credit can reduce your U.S. tax liability on a dollar-for-dollar basis.
- In general, the tax credit can lower your tax liability in the United States, but only up to the amount of foreign taxes paid or the U.S. tax liability on the foreign income — whichever is lower.
- If your foreign tax liability is higher, you may be able to carry the difference back to the previous year or forward to future years.
Who qualifies for this credit?
To qualify for the tax credit, the tax must meet all four of the following conditions:
- It must be legal and an actual foreign tax liability.
- It must be imposed on you.
- You must have either paid or accrued it.
- It must be an income tax or a tax in lieu of an income tax.
If the tax does not meet the above conditions, you cannot take the credit. There are exclusions that can prevent you from claiming this tax credit, including if the taxes are paid or accrued to a country under sanction by the United States. TurboTax will ask questions regarding any foreign taxes to help you properly deal with this tax credit opportunity on your tax return.
Investing in overseas fund companies
You can usually invest in many foreign companies using U.S. based investments, such as mutual funds. However, it's possible to buy mutual funds based in other countries. Be careful before you do, though. Owning a mutual fund from a foreign country may result in different tax treatment. And, if one of your investments is determined to be a passive foreign investment company (PFIC), it may be taxed at a much higher rate.
Which countries are most advantageous to invest in?
If you're investing in foreign countries using a U.S. based mutual fund, which countries should you focus your investment in? Ultimately, that decision lies with the individual investor, their goals, and their outlook on the future growth potential of the countries they're considering.
If a country is under sanctions, you won't be able to get a tax credit for qualifying taxes based on your investments in those countries. That means you'd have to pay taxes in both that country's and the United States.
You may also consider avoiding investments in countries with much higher taxes than the United States. Remember, the foreign tax credit is limited to whichever is lower — either:
- the amount of tax you'd have to pay in the United States or
- the amount of foreign taxes paid.
If you invest in countries with higher taxes than the U.S., your credit will be limited to the tax due in the United States.
Consider consulting a financial advisor to help you determine which countries best fit your investment needs. When it comes time to file your taxes, TurboTax can help to make sure you properly report your investment income and claim any eligible tax credits.
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