Depending on the type of investment you choose with foreign investment, you may have to face the foreign tax credit or other complex tax situations when you file.
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Why you might want to invest outside the United States
Investing in the United States can be a good entry point when you first start investing, but it is not the only place available to you. There are different reasons why you might want to consider investing outside of 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 is not the only one. Rather than investing only in companies in one country, you can also diversify your portfolio by investing globally.
- Diversifying your portfolio to include companies in other parts of the world can help you during times when the US economy may run out of steam, but other parts of the world are still growing.
- The opposite is also true. If companies in other countries that you have invested in start to decline while the United States is growing, your returns might not be as strong.
Even so, a properly diversified portfolio can give you an appropriate amount of exposure to help balance your portfolio returns when companies around the world have different returns.
To take advantage of rapidly growing regions of the world
The economies of different parts of the world are growing at different rates. At any time, there may be countries experiencing a growth spurt, which could lead to rapid growth of these companies. If you only invest in the United States, you might miss out on these opportunities.
How the foreign tax credit can help you
If you invest in foreign countries, you may be at a slight tax disadvantage, as other countries may tax investments based in their region. Due to the US tax system, you will also have to pay US taxes on these investments.
Fortunately, a tax credit can provide 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 eligible for the tax credit may reduce your US tax payable on a dollar-for-dollar basis.
- In general, the tax credit can reduce your tax payable in the United States, but only up to the amount of foreign taxes paid or US tax payable on foreign income, whichever is less.
- If your foreign tax payable is higher, you may be able to carry the difference over to the previous year or to subsequent years.
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Who is entitled to this credit?
To benefit from the tax credit, the tax must meet the following four conditions:
- It must be legal and subject to actual foreign tax.
- It must be forced on you.
- You must have paid or accumulated it.
- It must be an income tax or a tax in lieu of income tax.
If the tax does not meet the above conditions, you cannot qualify for the credit. There are exclusions that may prevent you from claiming this tax credit, especially if the taxes are paid or accrued in a country sanctioned by the United States. TurboTax will ask questions regarding foreign taxes to help you properly manage this tax credit opportunity on your tax return.
Invest in foreign fund companies
You can generally invest in many foreign companies using US based investments, such as mutual fund. However, it is possible to buy mutual funds based in other countries. Be careful before doing this, however. Owning a mutual fund in a foreign country may result in different tax treatment. And, if any of your investments are determined to be a Passive Foreign Investment Company (PFIC), it may be taxed at a much higher rate.
In which countries is it the most advantageous to invest?
If you are investing in foreign countries using a US-based mutual fund, which countries should you focus your investment on? Ultimately, this decision is up to the individual investor, their goals and outlook on the future growth potential of the countries they are considering.
If a country is under sanctions, you will not be able to obtain a tax credit for qualifying taxes on the basis of your investments in those countries. This means that you will have to pay taxes both in this country and in the United States.
You may also want to consider avoiding investments in countries where taxes are much higher than the United States. Remember that the foreign tax credit is limited to the lowest amount – either:
- the amount of tax you would have to pay in the United States or
- the amount of foreign taxes paid.
If you invest in countries where taxes are higher than the United States, your credit will be limited to the tax owed in the United States.
Consider consulting a financial advisor to help you determine the countries that best suit your investment needs. When it comes time to file your taxes, TurboTax can help you correctly report your investment income and claim any eligible tax credits.