How Foreign Stocks Affect Your U.S. Taxes

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Many investors are quite reasonably confused about the tax treatment of their foreign stock fund holdings. Joining me to discuss that issue and to share a couple of tax-friendly favorites is Morningstar analyst Dan Sotiroff.

Dan, thank you so much for being here.

Daniel Sotiroff: Hi Christine.

Benz: Dan, let's talk about how this works. Because if I own a foreign stock and it pays a dividend, I get taxed on that dividend in the country where the company is domiciled.

Sotiroff: Right, that's correct.

Benz: And then if I look at my 1099, I see a tax credit there. So the goal is to prevent me from paying taxes twice, right? Is that basically it?

Sotiroff: That's the whole idea, right. Like you said, when a foreign company pays a dividend, that government is going to withhold part of that dividend, so you're never going to really see the whole dividend actually come through. So, as sort of a service to U.S. investors, Uncle Sam kind of gives you this ability to write off that dividend that you've paid to the foreign government in the form of a tax credit.

Benz: So, the issue though, and this is one reason why people have had questions about asset location, "Where should I put my foreign stocks? If I've got my foreign stock fund, for example, in my IRA, well, that tax credit's not of any use to me, right?"

Sotiroff: Pretty much, yeah, it's kind of a waste. But you got to remember you're not being taxed twice. So, you're not paying taxes to the U.S. government.

Benz: Because it's in the IRA wrapper.

Sotiroff: Because it's in the IRA wrapper, you're already getting that tax deferral and that tax-free gain depending on Roth or non-Roth.

Benz: So, do you have guidance about where people should hold foreign stock funds? Does it matter?

Sotiroff: You know, in my view, it doesn't really matter, because again, you're being taxed somewhere at the end of the day, right? So if you hold that foreign stock fund in a taxable account, you take the tax credit, you're not being taxed by foreign governments, but you're still going to pay taxes to the U.S. government on that income at your normal income rate. And like we were talking about before, if you are going to put that fund in your IRA or a tax-advantaged account, you no longer pay the U.S. government, but you're still on the hook for paying something to these foreign governments. So at the end of the day, it's a very complicated calculation that ends up, you know, in a certain extent, depending on what your future tax rate is going to--you just don't know. So to me, it's kind of a wash, you know, I don't really let that decision or the tax advantage drive my asset-allocation decisions at the end of the day.

Benz: Nonetheless, if I hold a foreign stock fund in my taxable account, I probably do want to keep an eye on taxes because one thing we know is that dividends have been a little higher overseas, certainly in recent years than in the U.S., right?

Sotiroff: That's true. That's made them a little bit disadvantaged from a tax perspective. And that's just--that's been sort of a persistent characteristic of foreign stocks in general. It's caused a lot of people to kind of flock to foreign stocks a little bit because they offer higher yields, but again, none of that is really guaranteed to persist into the future. You don't really know--foreign stocks in general tend to have very volatile dividends. So it's very possible that those yields could come down in the future. We just really don't know. You shouldn't be letting these things sort of drive your long-term investment decisions. They're more of, like, of-the-moment type things.

Benz: Okay. So if I'm looking at my taxable account, and I want to try to reduce the tax drag there, you have a couple of exchange-traded funds, index funds that you like for the job. Couple of them are from Vanguard. Let's talk about those.

Sotiroff: Yeah, so the Vanguard funds are great, just because they sort of have this ETF share class that's bolted on to the mutual fund share class, right? So the ETF share class they have this in-kind redemption mechanism. So, what that dual share class structure at Vanguard allows them to do is sort of purge the capital gains from their mutual fund through the ETF structure. It makes their mutual funds very, very tax-efficient. And you know, as always, ETFs are a great way to go in general because of that mechanism that I was just describing. You know, you can not only add Vanguard but BlackRock, Schwab, State Street, etc. Very tax-efficient in general--the best way to go is with an ETF in general.

Benz: OK, so a shortlist of funds you like Vanguard Developed Markets Index, Vanguard Total International, Schwab International Index.

Sotiroff: And probably another thing that hit on there. Those are all just broad indexed. Very low turnover, very low cost, great advantage overall for a long-term investment.

Benz: Okay, Dan. Always great to get your perspective. Thank you so much for being here.

Sotiroff: Thank you.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.