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Investing Specialists

Should You Keep Foreign Stocks Out of Your IRA?

Tax considerations suggest yes, but other factors may argue against it.

Investors have fewer than two months to go in order to make an IRA contribution for the 2018 tax year; the deadline for contributions is the same as your tax-filing deadline, April 15.

I've often recommended that investors take a look at their portfolios' weightings to determine where to invest new IRA funds. If Morningstar's Instant X-Ray view shows that your portfolio is light on an asset class, Morningstar Style Box square, sector, or geographic region, you can use your new contributions to help address the imbalance.

For many investors conducting that exercise today, their portfolios may well look light on foreign stocks. While overseas markets have notched strong gains so far in 2019, 2018 was awful: The MSCI EAFE Index lost nearly 14% last year, about 8 percentage points worse than the U.S. market. Over the past decade, total international index funds have gained about half as much as U.S. total index funds on an annualized basis. That underperformance has given a valuation advantage to foreign stocks, however, and many market experts expect foreign markets to outperform the U.S. over the next decade. 

Yet even as long-term investors who are adding to or repositioning their IRAs might naturally be looking overseas, tax considerations make an IRA or other tax-sheltered vehicle a less-than-ideal receptacle for foreign stocks. But are those reasons significant enough to avoid foreign stocks in an IRA altogether? And if foreign stocks are an imperfect fit in an IRA, does that mean they’re better placed inside a taxable account?

Foreign Stock Tax Treatment in Taxable Accounts
To help address those questions, let's start by looking at the tax treatment of foreign stocks by U.S. investors. If a foreign stock pays a dividend to shareholders in other countries, the taxes due on that income may be withheld by the foreign government where the dividend-paying company is domiciled. Importantly, that reduces the amount of distributions the investment passes on to its shareholders outside the country. Such amounts are reflected on form 1099-DIV, in Box 7 ("Foreign tax paid"). In contrast, when U.S. taxpayers receive dividends from U.S. stocks, they receive the full dividend amount but settle up with the U.S. government via their tax returns; the government doesn't withhold the money. 

The hitch for foreign-stock investors is that the United States also taxes dividends that investors receive. To help U.S. taxpayers avoid having to pay taxes on the same foreign-stock dividend twice--once to the foreign country as well as to Uncle Sam--the U.S. government allows you to take a foreign tax credit or deduction to give credit for the taxes paid in the foreign country. The IRS describes the foreign tax credit on its site. According to the IRS' site, it's usually preferable to take the foreign tax credit rather than claiming the deduction. That's especially true starting with the 2018 tax year because you need to itemize your deductions in order to take advantage of the foreign taxes paid as a deduction, and many fewer taxpayers will be itemizing starting in 2018. Meanwhile, you can take advantage of the credit regardless of whether you itemize or not.

Foreign Stock Tax Treatment in IRAs
Things start to get really wonky when you hold a foreign stock or foreign stock fund in an IRA or other tax-sheltered account. If a foreign stock that you own--either directly or indirectly via a foreign stock fund or exchange-traded fund--pays you a dividend, your taxes due on that payout will be withheld by the foreign government, reducing your payout accordingly, as discussed above. But in contrast with the taxable account, where you have to pay tax on any income you receive on a year-by-year basis, the IRA, 401(k), or other tax-advantaged account isn’t subject to that same type of year-by-year accounting; you just owe taxes when you begin pulling money out. In that instance, your foreign-stock dividend may have been reduced by the amount of taxes you paid to a foreign government, but you can't be "made whole" on that dividend because you can’t take advantage of the credit you receive from the U.S. government. (Activities within your IRA aren't reflected on your tax return.)

Implications for 'Asset Location'
Is the natural extension of this tax treatment that you should hold your foreign stocks inside of a taxable account rather than an account like an IRA, the better to avail yourself of the tax credit (or deduction) that you have coming to you? Not necessarily. After all, it's not as though foreign stocks are particularly advantageous for taxable accounts but rather that they're particularly disadvantageous for tax-sheltered accounts. But that disadvantage doesn't entirely negate the fact that tax-sheltered accounts offer tax-deferred growth (traditional IRAs and 401(k)s) or tax-free growth (Roth accounts). Those long-term tax-saving features help make up for the dividends you received, paid foreign taxes on, and couldn't offset with a credit.

Moreover, a countervailing reason against holding foreign stocks in a taxable account is that dividends are often higher overseas than in the U.S. Thus, even though the foreign stock investor receives a credit for dividend taxes paid overseas to avoid double taxation, the foreign-stock dividends may be higher in absolute terms. Higher dividends inside a taxable account lead to higher taxes, regardless of the fact that you receive a foreign tax credit to help ensure that you don't pay taxes twice. Foreign stock index funds currently have yields in the neighborhood of 3%, for example, whereas U.S. total market index funds have yields of roughly 2%. For that reason, investors in the highest tax brackets have ceded about 10% of their returns, in the form of tax-cost ratios, on foreign large-blend funds over the past decade, whereas the same investors in U.S. large-blend funds have surrendered about 9% of their gains to taxes. (Tax-cost ratios for U.S. stock funds tend to be higher than foreign stock funds’, but U.S. stock funds' returns have also been much higher.)

Whether to put a foreign stock fund inside an IRA or a taxable account also depends on the nature of the fund. If you own a high-turnover foreign-stock fund, for example, that will be a bad bet for a taxable account no matter what. That's because 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. Ultimately, tax credits are just one factor in the decision about whether to hold foreign stocks in a tax-sheltered account or taxable one. The long-term advantages of having your assets compound inside of a tax-sheltered account are important, too, and they're not wholly negated by forgone tax credits.