Question: Someone told me that each year I pay taxes on the dividends from the foreign-stock funds held in my IRA. If I'm not supposed to be paying taxes on dividend payments in my IRA, how can this be?
Answer: To understand why you may be paying taxes on foreign dividends held in your IRA (and your 401(k), if you have one) you first must understand how the U.S. tax code treats the income U.S. taxpayers receive from abroad.
Just as the U.S. government taxes dividends and interest paid out by U.S. companies and bond issuers, so, too, do foreign governments tax dividends and interest paid out in their countries. The tax on this foreign investment income may be withheld at the source, before it is distributed to a U.S.-based mutual fund, thus reducing the amount of distributions the fund passes on to its shareholders. Likewise, U.S. investors who own shares of foreign companies through financial arrangements known as American depositary receipts, or ADRs, which are bought and sold on U.S. exchanges or in the over-the-counter market, also may find that part of their foreign investment income has been withheld by the company's home country. (For more on how ADRs work, see this recent Short Answer article.)
Avoiding Double Taxation
In order to avoid making U.S. investors pay taxes on overseas income twice, the tax code allows them to take a foreign tax credit or deduction (depending on the circumstances) on their federal income tax returns. This credit or deduction can help lower the amount you owe the Internal Revenue Service for foreign investment income you've received, or even offset it completely. You may even be able to use any excess foreign tax credit to offset taxes paid the prior year or hold onto it for use for up to 10 years.
Under tax treaties between the United States and many countries, foreign dividends may be subject to taxation at the qualified dividend rate (currently 15% for single filers with taxable incomes below $400,000 and $450,000 for joint filers) as opposed to ordinary income rates. At the end of each tax year investors should receive a 1099-DIV form that shows (in Box 6) the amount of foreign taxes paid on the their behalf for income received from overseas investments.
No Foreign Tax Relief for Retirement Accounts
This is all well until you consider that tax-advantaged retirement accounts such as IRAs and 401(k)s are constructs of the U.S. tax code that aren't recognized by foreign countries. For foreign shares held in these accounts, shareholders must still pay taxes on income the shares generate in their country of origin. But because IRA accountholders don't pay taxes on investment income on a year-to-year basis, they can't use the foreign tax credit or deduction on foreign investment income. Thus, any income distributed in an IRA or 401(k) account from U.S.-based sources will be untaxed, but any income distributed from foreign sources will have been reduced by any foreign taxes paid on those distributions, with no way for the accountholder to offset those foreign tax payments by using the foreign tax credit or deduction.
So does this mean you should always hold foreign income-producing investments in a taxable account in order to take advantage of the foreign tax credit and deduction? Not necessarily. After all, the tax-free growth of a foreign investment may more than make up for any reductions from paying foreign income tax. (Keep in mind that capital gains on sales of foreign securities are paid to the U.S. government and not the foreign government, so the foreign tax credit/deduction would not apply.) For example, it may make more sense to hold an emerging-markets stock fund that provides relatively little income but spins off large capital gains in a tax-advantaged retirement account to avoid paying taxes on those gains. Also, because foreign investments can play an important role in diversifying a retirement portfolio, holding them outside your tax-advantaged retirement account can complicate asset-allocation considerations.
If you do plan to use foreign investments as part of your retirement portfolio, there is a modest advantage to holding them in a traditional IRA or 401(k) as opposed to a Roth, says Rande Spiegelman, vice president of financial planning for the Schwab Center for Financial Research. In either case the investor loses out on using the foreign tax credit or deduction. But with foreign distributions in a traditional IRA or 401(k), you are essentially paying a tax now on income that would later have been taxed anyway when you make withdrawals from the account. However, with foreign distributions in a Roth, you are essentially paying a tax now on income that would never be taxed if it were from domestic sourcesbecause a Roth provides tax-free withdrawals.
Spiegelman says foreign securities held in other tax-advantaged savings vehicles, such as 529 college-savings plans or Coverdell Educational Savings Accounts, would suffer from similar tax treatment as the Roth, making them less tax-efficient compared with a taxable account or a traditional IRA or 401(k). Tax treatment of foreign investments held in a variable annuity, on the other hand, would be more akin to that of a traditional IRA, Spiegelman says, because taxes are deferred until money is withdrawn.
Letting the Tax Tail Wag the Investment Dog
But while some tax-savvy investors might be tempted to structure their portfolios in such a way that foreign income sources remain in taxable accounts, this strategy can be overdone, says Spiegelman.
"When it comes to foreign investments and the foreign tax credit, it's probably the last thing I would worry about in terms of tax placement," Spiegelman says. "I just don’t think it's that big of a deal."
Spiegelman points out that for most investors, the amount of foreign tax paid on their investments probably amounts to no more than few hundred dollars at most. Meanwhile, the value of diversification far outweighs the potential benefit of managing your retirement portfolio to optimize tax efficiency, he notes. Spiegelman also says investors who pay too much attention to tax considerations can lose focus on more important matters. "It's not about paying the least amount of tax, but it is about maximizing your aftertax income," he says. "Don't let the tax tail wag the investment dog."
A version of this article appeared Feb. 5, 2013.