How to foreign tax paid by your mutual fund affects your tax return.

Some mutual funds invest overseas. These funds are likely to incur foreign taxes on interest and dividends. If the mutual fund meets certain requirements it can allocate this foreign tax to its shareholders, providing them with a tax benefit.

If you receive a foreign tax allocation you have a choice. You can claim the foreign tax as an itemized deduction. or you can claim a foreign tax credit. The itemized deduction is quick and easy — but provides a small benefit (and in some cases, none at all). The tax credit usually provides a larger benefit — but may be difficult to calculate. Many people take the deduction because it’s easier, even though it means paying more tax. Ever since 1998, though, the IRS has offered a simplified method to claim the credit.

Finding the numbers

Foreign tax paid will be reported in box 6 of Form 1099-DIV, Dividends and Distributions. You should receive this form (which may be printed as part of an annual report) from your mutual fund or broker in January or early February. If you find a form labeled 1099-DIV but there’s no box 6, it probably means your mutual fund didn’t make a foreign tax allocation for the year. If you’re uncertain, contact your mutual fund or broker for clarification.

In addition to the amount of foreign tax paid, you need to know how much foreign income you had if you claim the foreign tax credit. This isn’t necessarily the same as the total amount of the dividend because the mutual fund may have some United States investments even if it’s designed to invest primarily overseas. Furthermore, unless you use the simplified method described below for calculating the credit, you’ll need to know what country (or countries) the foreign income and tax relate to. There’s room on Form 1099-DIV to enter the name of a country, but many mutual funds have foreign income from more than one country. These types of information are contained in an annual report you’ll receive from the mutual fund or from your broker. Usually this report comes at the same time as the Form 1099-DIV.

Deducting the foreign tax

The deduction for foreign tax paid is available only if you itemize. You can’t claim this deduction if you use the standard deduction. If you don’t itemize, consider claiming the foreign tax credit, as explained below.

If you itemize, it’s a simple enough matter to claim the deduction. Add the foreign tax from all Forms 1099-DIV you receive and enter the total on line 8 of Schedule A, Itemized Deductions. Describe it as foreign tax from 1099-DIV. If you have any other items that go on line 8, add them together and enter a single total but describe each one separately in the space provided.

Although this is the simplest way to handle foreign tax, it’s not likely to be the one that saves the most tax. You can usually do better if you claim the foreign tax credit.

Claiming the foreign tax credit

The foreign tax credit is designed to prevent double taxation. If you’re able to make full use of it, you’ll get a larger tax benefit than if you claim a deduction for foreign tax paid. The reason is that a credit reduces your tax while a deduction only reduces your income.

Example: You’re in the 25% tax bracket and you have a choice between a $100 deduction or a $100 credit. If you claim the $100 deduction, your income goes down by $100, and your tax goes down by $25. If you claim the $100 credit, your tax goes down by $100.

At this point it sounds like a no-brainer: take the credit, not the deduction. But there are two reasons the deduction may be the better choice:

• The foreign tax credit limitation may prevent you from getting full value from the credit.
• The form needed to claim the credit is complicated.

Foreign tax credit limitation

You don’t automatically get to claim the full amount of foreign tax paid as a credit. The law is designed to limit this credit to the amount of United States tax you would otherwise pay on the same income.

Example: You receive $1200 foreign income and pay $360 foreign tax. Due to your low tax bracket and various deductions, your United States tax on this income is $250. That means you can only claim $250 as a credit.

Of course, if the reverse were true (you paid foreign tax of $250 when your United States tax on the same amount would be $360) you still get only $250 credit because that’s all the foreign tax you paid. You always pay the smaller amount: the foreign tax or the limitation amount.

In most cases, even when the limitation applies you come out better with the credit than with the deduction. In unusual cases the deduction will work out to a larger tax savings than the credit.

Form 1116

The other reason people claim the deduction instead of the credit is that you have to fill out a complicated form to claim the credit. Not only is the form somewhat complicated, but you have to track down information and perform some calculations that are not shown on the form.

Beginning in 1998, however, the IRS adopted a procedure where you can claim the foreign tax credit without filing Form 1116 if your total creditable foreign taxes are $300 or less ($600 or less on a joint return) and you meet certain other requirements. That’s a boon for many taxpayers, because the tax benefit on small amounts was often too great to justify the hassle involved in filling out the form. Check the instructions for Form 1116 to see if you qualify.