Foreign Stock Funds Can Be Doubly Taxing

December 16, 2016

Many U.S. investors hold foreign stocks.  One of many advantages to holding foreign stocks is diversification because  some foreign companies might outperform domestic stocks in bear markets. Some foreign countries, especially those in the developing world, are posting stronger economic growth than the American numbers. What’s more, virtually every sizable nation boasts  some excellent companies that are likely  to reward investors. To find the best opportunities abroad, many U.S. investors use foreign stock mutual funds, to benefit from the fund companies’ research and portfolio management expertise.

There may be another reason to invest in a foreign stock fund: Some foreign companies pay relatively high dividends. However, that may lead  to double taxation and lower effective yields.

Example 1: Sheila Tucker invests $40,000 in a foreign stock fund. This fund pays a 5% dividend, so Sheila would earn $2,000 (5% of her $40,000 investment) a year. However, the host countries where the companies are based might withhold, say, 20% of the dividend payments ($400), to cover the tax due on those dividends. Thus, Sheila effectively pays tax on that $2,000 in dividends to the host countries, and pays tax again, to the IRS this time, when the foreign stock fund reports the dividend income generated by the foreign stocks.

Trimming the tax

Fortunately, there may be a way for investors such as Sheila to reduce this double tax burden. Foreign stock funds will report taxes paid via withholding on Form 1099-DIV. Then, investors may be able to claim a foreign tax credit up to $300 a year ($600 for couples filing jointly) directly on their Form 1040. (A deduction for foreign taxes paid may be taken on Schedule A, instead, but the credit is generally a greater tax saver.)

However, taking a foreign tax credit can become complicated if your foreign tax withholding exceeds the amounts mentioned in the previous paragraph, or if the tax withheld exceeds the tax due to the IRS. Then, the deduction cannot be taken directly on Form 1040, and Form 1116 must be filed; our office can assist with that form, if it’s necessary.

Tax relief through the foreign tax credit (or a foreign tax deduction) won’t help, though, if you hold a foreign stock fund in a tax-deferred account such as an IRA.

Example 2: As mentioned, Sheila Tucker has $2,000 in dividends from a foreign stock fund in 2016, and the host countries withhold $400 in tax, at a 20% rate. In this example, though, the fund is held in her IRA. Sheila does not report this dividend income to the IRS for 2016, because the money is in her IRA, so she can’t claim a tax credit. Eventually, when Sheila withdraws the dividend income from her IRA, she’ll owe tax at ordinary income rates.

As these examples indicate, the amounts involved may be modest, for many investors. If the advantages of investing in foreign stock funds appeal to you and your only practical choice is to use a tax-deferred account, double taxation may not be a meaningful drawback. If you do have options, though, you may find it more tax-efficient to hold foreign stock funds in a taxable account and use the credit. Similarly, if you invest in individual dividend-paying foreign stocks, you may want to hold them in a taxable account, if possible.