If you paid income taxes to foreign countries, you may be able to take a deduction or a credit. What you decide to do depends on your particular situation and which will save you the most money. If you decide to take the deduction, then your U.S. taxable income will be decreased. This will decrease the amount of income you’re taxed on, so it will reduce your taxes. When you take the foreign income tax paid as a credit, you are reducing your tax liability. Depending on your particular tax situation, most individuals do take the credit to reduce the amount in U.S. income tax that is owed. Just keep in mind that it is not possible to take both a credit and a deduction. There may, however, be other types of foreign taxes that you can deduct to reduce your taxable income. Click here to read or watch more IRS Help resources.
When to take the deduction
It is in the interest of most taxpayers to take the credit because it is nice to see the amount of the tax owed decrease and it usually does result in more money saved. There are, however, times in which the deduction is going to be the best choice. The main issue is when the foreign income is taxed at a high rate, but is just a small portion of the gross income earned. If your U.S. earned income far exceeds the amount of foreign income earned, then you may find that it benefits you more to take the deduction and decrease the amount of income you can be taxed on. You will get a lower final tax than what you would with the credit.
The best way to decide whether you should take the deduction or the credit is to figure your income both ways and see which gives you the lowest tax liability in the end. Although the foreign income may not be a substantial amount of your income, you may find that you can save quite a bit.
If you find later that you could have saved more on your taxes, you do have ten years from the tax due date to make changes to that return. You do not have to settle with taking less money than what you could have when you do have the opportunity within such a long period to make the necessary changes.
Foreign income taxes
When you pay foreign income taxes, they can only be taken as a credit on your tax return. You have to take them as an itemized deduction on your Schedule A and transfer that information over to your 1040. You need to make sure you don’t claim your foreign income taxes as withheld income because these foreign taxes do not fall in that category.
If your foreign income is excluded from tax, you can’t claim any credit or deduction. If you have chosen to exclude foreign housing, foreign income, or any foreign possessions, you cannot claim the deduction or credit. If you include the income, then you can include the credit or deduction. This is another instance in which you may want to weigh your options. Do the math and see which works better for you. The same goes if you have excluded just part of your foreign income.