Wednesday, April 6, 2011

Put your excess foreign tax credits to work

If as an American you’ve live in Spain long enough that your Beckham tax rate has expired and you are back to the marginal 45% tax bracket, your US rate will be lower than your Spanish. This means that effectively you won’t be taxed at all in the US on your Spanish income, and will in fact have an excess foreign tax credits.

Unfortunately you can’t use foreign tax credits against purely US income, so you may end up with more than you can use if you live here for a while.

One other limitation is that there are two baskets of foreign tax credits, “passive” and “general category”, which are each limited by the amount of income you have in that category. This can be somewhat annoying in Spain, since your salary, which is “general category” is taxed higher than interest, which is “passive” category.

What are these good for?

  • If you US paid taxes on foreign income in the last two years, you can file an amended return and “carryback”. Since amended returns get extra scrutiny from the IRS, make sure that your returns for years when you expect to get a carryback are bulletproof. For example, the last two years of your “Beckham tax” status.
  • The US/Spain tax treaty states that pension income is only taxed in the country of residence.
    • IRA distribution or Roth conversions are considered “pension income”
    • Spain does not recognize the concept of deferred income
    • As a US citizen, you must still include the IRA distribution taxable income
    • However, you can use the US tax treaty to treat the IRA income as Spanish income, and then apply any excess foreign tax credits against taxes you’d pay in the US.
    • If you are under 65, you may want to do a Roth IRA conversion, rather than a withdrawal in order to avoid the 10% penalty.

If you have a substantial IRA, you can use this strategy to use the higher taxes you pay in Spain to offset taxes that you’d have to pay in the US.

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