How to Claim the VXUS Foreign Tax Credit on Your Taxes

Investors holding Vanguard Total International Stock ETF (VXUS) may notice that a portion of their dividends is subject to foreign taxes. The U.S. tax code allows investors to claim a credit for these taxes, potentially reducing their overall tax liability. However, the process involves specific calculations and IRS forms that must be completed correctly. Understanding how to claim this credit ensures you’re not paying more in taxes than necessary.

Qualifying Dividends from VXUS

Dividends from VXUS come from a mix of foreign companies, and not all qualify for lower tax rates. The IRS categorizes dividends as “qualified” or “nonqualified,” with qualified dividends taxed at the lower long-term capital gains rate and nonqualified dividends taxed as ordinary income.

To be considered qualified, the stock must be from a country with a U.S. tax treaty, and the investor must hold VXUS shares for more than 60 days within a 121-day window surrounding the ex-dividend date. If these conditions aren’t met, the dividends are taxed at the higher ordinary income rate.

VXUS includes stocks from both developed and emerging markets, meaning some dividends won’t qualify due to the tax status of the issuing country. For example, dividends from companies in Argentina, which lacks a U.S. tax treaty, are automatically nonqualified. Meanwhile, dividends from companies in treaty nations like Canada or the United Kingdom are more likely to qualify. Vanguard provides an annual breakdown of qualified versus nonqualified dividends in its tax documents, which investors should review when preparing returns.

Calculating Foreign Taxes

The foreign taxes withheld from VXUS dividends depend on the tax rates imposed by the countries where the underlying stocks are based. These rates vary significantly. The United Kingdom does not withhold taxes on U.S. investors, while France imposes a 25% withholding tax. Vanguard reports the total foreign taxes withheld on Form 1099-DIV, specifically in Box 7, which serves as the starting point for determining the foreign tax credit.

To calculate the maximum credit, investors must determine the portion of their total taxable income that comes from foreign sources. This requires identifying the foreign-source income from VXUS dividends, which Vanguard reports annually as a percentage of total dividends. If foreign taxes exceed the allowable credit limit, the excess can be carried forward for up to ten years or back one year, subject to IRS rules.

Since foreign taxes are withheld in local currencies, they must be converted into U.S. dollars using the exchange rate on the date of payment. The IRS does not mandate a specific source for exchange rates but expects consistency. Many investors use the yearly average exchange rate published by the IRS, though daily rates can be used if properly documented.

Filing with Form 1116

Claiming the foreign tax credit for VXUS typically requires IRS Form 1116, which calculates the credit based on taxable income, foreign-source earnings, and U.S. tax obligations. If foreign taxes are $300 or less for single filers ($600 for joint filers), the credit can often be reported directly on Schedule 3 of Form 1040 without Form 1116.

VXUS dividends generally fall under the “passive category income” section of Form 1116. Within this section, investors must allocate their foreign-source income, subtract related expenses, and determine the allowable credit using the formula: foreign taxable income divided by total taxable income, then multiplied by U.S. tax liability. If the credit is limited, taxpayers may need to carry forward or carry back excess amounts.

Errors on Form 1116 can lead to IRS scrutiny. Common mistakes include misallocating foreign income, failing to adjust for foreign tax refunds, or incorrectly applying deductions that reduce foreign taxable income. The IRS may disallow a portion of the credit if documentation does not support the claimed amount. Tax software can assist with calculations, but reviewing IRS instructions for Form 1116 helps ensure accuracy.

Record Retention Requirements

Keeping thorough records is essential when claiming the foreign tax credit, as the IRS may request supporting documents. Investors should retain copies of Form 1099-DIV, which details foreign taxes withheld, along with brokerage statements confirming dividend payments. These records substantiate tax return entries and help resolve discrepancies if audited. Since financial institutions may not keep historical tax documents indefinitely, downloading and storing digital copies ensures accessibility.

Taxpayers should also keep records of any foreign tax reclaims filed with international tax authorities. Some countries allow investors to recover a portion of withheld taxes through refund applications, which could impact the credit claimed. If a refund is received after filing a U.S. tax return, an adjustment may be required the following year to avoid overstating the credit. Correspondence with foreign tax agencies and proof of reclaims should be preserved to justify any modifications.

Handling Carryovers

If the foreign tax credit exceeds the allowable limit in a given year, the excess can be carried forward for up to ten years or back to the previous year. This flexibility helps investors maximize their tax benefits, particularly when foreign taxes are high relative to U.S. tax liability. However, unused credits expire if not applied within the allowed timeframe.

Tracking carryovers requires detailed records of prior-year credits. Form 1116 includes a section for reporting carryovers, where taxpayers document the amount carried forward, the year it originated, and how much is being used in the current filing. If foreign income varies significantly from year to year, planning may be necessary to ensure credits are used before they expire. Investors with substantial carryovers should monitor taxable income levels and consider timing investment decisions, such as realizing capital gains, to create opportunities for applying unused credits.