Question: Someone told me that every year I pay taxes on dividends from foreign equity funds held in my IRA. If I’m not supposed to pay tax on dividend payments in my IRA, how can that be?
Reply: To understand why you can pay taxes on foreign dividends held in your IRA (and your 401 (k), if you have one), you must first understand how the U.S. tax code treats the income that U.S. taxpayers receive. from abroad.
Just as the U.S. government taxes dividends and interest paid by U.S. corporations and bond issuers, foreign governments also tax dividends and interest paid in their country. Tax on this foreign investment income can be withheld at source, before it is distributed to a US-based mutual fund, thereby reducing the amount of distributions that the fund passes on to its shareholders. Likewise, U.S. investors who own shares of foreign companies through financial arrangements known as U.S. Certificates of Deposit, or ADRs, which are bought and sold on U.S. exchanges or in the over-the-counter market. , may also 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.)
Avoid double taxation
In order to prevent U.S. investors from paying taxes twice on foreign income, the tax code allows them to claim a foreign tax credit or deduction (depending on the circumstances) on their federal income tax returns. . This credit or deduction can help reduce the amount you owe the Internal Revenue Service for foreign investment income you received, or even offset it completely. You can even use any excess foreign tax credit to offset taxes paid in the previous year or keep it for up to 10 years use.
Under tax treaties between the United States and many countries, foreign dividends may be taxed at the qualifying dividend rate (currently 15% for sole filers with taxable income less than $ 400,000 and $ 450,000 for joint filers) as opposed to regular income rates. At the end of each fiscal year, investors should receive a Form 1099-DIV which shows (in Box 6) the amount of foreign taxes paid on their behalf for income from overseas investments.
No foreign tax relief for retirement accounts
All is well until you consider that tax-advantaged retirement accounts such as IRAs and 401 (k) are constructions of the US tax code that are not recognized by foreign countries. For foreign stocks held in these accounts, shareholders must still pay taxes on income generated from the shares in their home country. But because IRA account holders do not pay taxes on investment income on an annual basis, they cannot use the foreign tax credit or the foreign investment income deduction. Thus, any income distributed into an IRA or 401 (k) account from sources based in the United States will not be taxed, but any income distributed from foreign sources will have been reduced by any foreign tax paid on those distributions, with no way for the account holder to offset these foreign tax payments using the foreign tax credit or deduction.
So does this mean that you should always hold income producing foreign investments in a taxable account in order to take advantage of the foreign tax credit and deduction? Not necessarily. After all, the tax-exempt growth of a foreign investment can more than offset any reduction in foreign income tax. (Keep in mind that capital gains on sales of foreign securities are paid to the US government, not the foreign government, so the foreign tax credit / deduction would not apply.) For example It may make more sense to own an emerging market equity fund that provides relatively little income but generates large capital gains in a tax-advantaged retirement account to avoid paying taxes on those gains. Additionally, because foreign investments can play an important role in diversifying a retirement portfolio, holding them outside of your tax-advantaged retirement account can complicate asset allocation considerations.
If you plan to use foreign investments as part of your retirement portfolio, there is a modest benefit to holding them in a traditional or 401 (k) IRA as opposed to a Roth, says Rande Spiegelman, vice president of financial planning for the Schwab. Financial Research Center. In either case, the investor loses using the credit or the foreign tax deduction. But WWith foreign distributions in a traditional or 401 (k) IRA, you are essentially paying income tax now that would later have been imposed anyway when you make withdrawals from the account. However, with foreign distributions in a Roth, you are essentially paying income tax now that would never be taxed if it were from domestic sources. because a Roth offers tax-free withdrawals.
Spiegelman asserts that foreign securities held in other tax-advantaged savings vehicles, such as 529 education savings plans or Coverdell education savings accounts, would receive similar tax treatment as Roth, which would result in them being taxed. would make it less tax advantageous compared to a taxable account or a traditional account. IRA or 401 (k). The tax treatment of foreign investments held in a variable annuity, on the other hand, would be more akin to that of a traditional IRA, according to Spiegelman, because taxes are deferred until the money is withdrawn.
Let the fiscal tail wag the investment dog
But while some tax-savvy investors might be tempted to structure their portfolios so that foreign sources of income remain in taxable accounts, this strategy may be overkill, Spiegelman explains.
âWhen it comes to foreign investment and the foreign tax credit, that’s probably the last thing I would worry about in terms of tax investment,â Spiegelman said. “I just don’t think that’s a big deal.”
Spiegelman points out that for most investors, the amount of foreign tax paid on their investments is probably not more than a few hundred dollars at most. Meanwhile, the value of diversification far outweighs the potential benefit of managing your retirement portfolio to maximize tax efficiency, he notes. Spiegelman also says investors who pay too much attention to tax considerations may lose focus on more important issues. âIt’s not about paying the least tax, it’s about maximizing your after-tax income,â he says. “Don’t let the tax tail wag the investment dog.”
A version of this article was released on February 5, 2013.