What Is the Foreign Tax Credit, Really?
(Or, More Importantly, What It Isn’t)
What the Foreign Tax Credit (FTC) Is:
A credit that is meant to prevent US citizens who reside in another country from being taxed twice on the same income. The US must have a double-taxation treaty with that other country. Spain currently does.
It is limited to your US tax liability. What does that mean? If you paid the equivalent of $18k USD in Spanish taxes, and your US tax liability is $10k USD, your FTC will be limited to $10k USD. You will not receive the additional $8k as a refund. If the $8k is eligible as a FTC, you can carry it forward to next year.
**Why I do not like the term “dollar-for-dollar credit”:
Calling the FTC a “dollar-for-dollar credit” happens a lot on the internet, and in some instances, it is true. However, this phrase tends to mislead many people into believing they will never again owe money on their US taxes. This is not true because the FTC does not cover all types of income and/or taxes. For example, it does not entirely cover the tax liability on interest, dividends, and/or self-employment tax, so you may still owe taxes to the IRS.
What the FTC Is Not:
It is not the same thing as the Foreign Earned Income Exclusion (FEIE). You cannot use both to cover a tax liability for the same type of income.
As mentioned above, it doesn’t necessarily cover all of your US tax liability. If you are self-employed, the IRS taxes your net income, but also requires you to pay self-employment tax, which pays into your social security and Medicare. If you were a W-2 employee, your employer would typically withhold that money and pay it for you. When you are self-employed, you must pay it yourself. It is separate from income tax and is not covered by the FTC.
**If you are registered as Autonomo in Spain and pay into the Spanish social security system, you may be able to get your US self-employment tax waived.
It is not free money (in other words, it is not refundable). What does this even mean? It is the same explanation as number 2 in the What It Is section: If you paid the equivalent of $18k USD in Spanish taxes, and your US tax liability is $10k USD, your FTC will be limited to $10k USD. You will not receive the additional $8k as a refund. If the $8k is eligible as a FTC, you can carry it forward to next year.
**What a Refund Really Is:
A refund is money that you already paid into the tax system, either through withholding on your paycheck or quarterly estimated taxes. When you file your yearly tax return and the amount you owe is less than the amount you already paid in, you get a refund.
Ex: You paid $25k throughout the year via withholding or quarterly estimated taxes, but the amount you owe (your tax liability) on your yearly federal tax return is $20k, so you overpaid $5k and you get that $5k back as a refund. A refund is not money that the IRS chooses to freely give you. There are a few credits that are refundable, meaning you may get that money even if you did not overpay your taxes, but the FTC is not one of them.
Common Misconceptions of the FTC:
It will make the taxes you owe to your new country similar to what you’re used to paying in the US.
The truth: Every country has its own tax laws, and the two systems do not talk to each other or work together. Often, the other country’s tax rates (in this example, Spain) are higher than what you are used to paying in the US. So, your Spanish tax bill may be higher than you were expecting. The FTC cannot lower your Spanish tax bill.
It will zero out the taxes you owe to both countries.
The truth: Its primary purpose is to prevent a person from being taxed twice for the same income, so you have to pay for it once somewhere.
The necessary disclaimer: This information is, by its nature, general and does not necessarily apply to every tax situation. Also, US tax law changes often. For specifics on your situation, please consult a tax professional.
In addition, this was written by an actual human and not A.I.