Foreign tax credit for Income resourced by treaty category when converting Traditional to Roth IRA

[kmdharan]

My wife and I are retired US citizens living in Portugal and are tax residents here. All our financial assets are in the US, which include IRAs and investment accounts. We qualified under the NHR tax regime here in Portugal, which lasts 10 years. During this period, most US source income is exempt from taxation in Portugal, except that  private pensions (including distributions from IRAs) are taxable at a flat rate of 10%. After the 10-year NHR period, all world-wide income becomes taxable at normal rate, which very quickly exceeds 50%.

To prevent falling into these very high tax brackets in the future, I am planning to draw down my Traditional IRAs to ensure that there are no RMDs after the NHR period. I plan to move some of that into taxable accounts and some into Roth IRA accounts. Since Roth withdrawals are also taxable in Portugal, we need to be careful to only move to Roth the amount that we don't expect to need while in Portugal.

So here is the question - if we withdraw from traditional IRAs and convert to Roth IRA, can we claim the 10% of tax paid in Portugal for foreign tax credit on Form 1116 in the category of Income resourced by treaty? While the treaty is quite clear that the amount of tax paid to Portugal can be claimed for foreign tax credit to avoid double taxation, I am not clear if Trad to Roth conversion is covered under this clause. Any expert advice will be much appreciated.

[dmertz]

I can't answer this one.

[kmdharan]

Can anybody else answer this question? I would think others have had a similar situation in the past....

[stephnyc]

Hey there...Did you ever figure this out?  I have the exact same question. I'm living in Portugal and ever year I do a Traditional IRA to ROTH IRA conversion.  I would really appreciate any info and I'm sure others must have this question.  Thanks!

[SusanY1]

Yes, you can take a tax credit for the taxes paid on the income that is re-sourced per the treaty.  

Further, since the position involves only pensions or other renumeration in consideration of past employment, it will also meet the exception for the requirement to file Form 8833, the Treaty-based tax return disclosure form.  
 

[kmdharan]

Unfortunately, no one has replied on this forum, but from the best available information, a Foreign Tax Credit on Form 1116 under the category of Income resourced by treaty should be available for the amount of tax paid to Portugal on Traditional IRA distributions (including Roth conversions) reported on a 1099-R. That is the position I plan to take, unless I am told otherwise. 🙂

[kmdharan]

Thanks, SusanY1. That helps a lot. Your message posted while I was compiling mine! 

[stephnyc]

I thought that the Foreign Tax Credit (FTC) could only be taken on foreign-sourced income. This is what Bright! Tax professionals have said.

[SusanY1]

This is generally true, except when the income is "re-sourced by treaty".  In the absence of a tax treaty, this income would not be eligible for the foreign tax credit.  However, with a treaty that specifically addresses that the income is taxable in the resident state, it becomes "re-sourced by treaty" for purposes of determining allowable credits. 

 @stephnyc 

[kmdharan]

**

[kmdharan]

Hello @SusanY1, thanks for your replies. Going back to my original question in this post, can you confirm that this FTC for taxes paid in the resident country (Portugal in my case) on the basis of "Income resourced by Treaty" applies to all distributions from Traditional IRA and 401(k), including Roth conversions?

And secondly, can you also confirm that it is possible to complete Form1116 for this purpose in the online version of Turbotax, stating the exact procedure for this, please?

[DaveF1006]

Regarding your first question, the Foreign Tax Credit (FTC) for taxes paid in the resident country (Portugal, in your case) based on "Income resourced by Treaty" can apply to distributions from traditional IRA and 401(k), including Roth conversion.  These distributions qualify under the treaty provisions. Since the money is taxable in both countries, you can claim the FTC.

To claim the foreign tax credit for taxes paid to Portugal

1. Go to Federal
2. Deductions and credits 
3. Estimate and other taxes paid 
4. Foreign Tax Credit>start  

[stephnyc]

Confirmation from a Portuguese tax professional (Conceito). Watch this YouTube webinar that “Expats Portugal” posted. It’s called “Tax Updates for Expats in Portugal” and it’s dated September 2024. 

https://www.youtube.com/watch?v=fJgF09GBQFw

[kmdharan]

@stephnyc , thanks for posting the link. It is absolutely certain that IRA and 401(k) distributions will be taxed in the state of residency (Portugal), although I believe the 85/15 rule explained in the video only applies to Roth IRA distributions and Traditional IRA distributions where you have an after-tax contribution basis, but are not able to trace your exact amount of after-tax contributions. As I understand the rules, you are only allowed to claim exemption for the exact amount of your after-tax contributions if it is possible to trace your contributions. But, as the speaker mentioned, this maybe subject to interpretations.

Nevertheless, the biggest unknown seems to be on how Traditional to Roth IRA conversions are treated for taxation in Portugal, which the speaker does not address. On the one hand you could argue that since a Roth conversion just moves money from one retirement account to another, and since distributions from both are taxable in Portugal, conversion itself should not be a taxable event. On the other hand you could argue that since you are changing the after-tax basis by moving it to Roth, you should pay the tax at the time of conversion and claim an exemption for that amount later when you take a distribution from Roth. The good news is that the US will grant you an FTC for the amount of tax paid to Portugal, whichever way you decide to interpret the Portuguese tax rules.

In my opinion, it is better to pay the tax in Portugal at the time of conversion from Trad to Roth IRA and take the FTC against the US taxes due. In the future if you do take a distribution from Roth, then you will not owe any tax in the US and you can legitimately claim an exemption from Portugal for the previously taxed amount and thus avoid double taxation. I would like affirmation for this logic from a tax expert, if possible.