Retirement savers have been plowing money into foreign stocks, but experts say many are failing to consider taxes and how the investments fit within their overall plan.
Foreign stock mutual funds accounted for $722 billion in workplace retirement accounts, including 401(k) plans, and in individual retirement accounts last year, says the Investment Company Institute, a mutual fund trade group, a more than 80 percent increase in just two years.
As investors pile on, however, many fail to realize their foreign dividends are subject to tax, even though their money is sitting in tax-deferred retirement accounts. And some are so caught up in avoiding the taxes that they never consider the overall relative merits of where to locate these assets - taxable or tax-deferred accounts - as they buy foreign stocks and bonds, experts said.
When an investor buys any stock or mutual fund in a taxable account, dividends on that investment are subject to U.S. tax. But a foreign country also might withhold local taxes on those dividends if they were generated in that country, so U.S. taxpayers holding international funds in taxable accounts generally are eligible for a U.S. tax credit or deduction to keep them from being taxed twice on the same investment.
If your fund withheld these taxes, you are notified on your year-end tax statement from your fund company, and you can determine whether it is better to take a credit or deduction, depending on your situation.
Retirement account holders, on the other hand, can't recoup withheld taxes from the foreign country, because they don't account for the gains on their personal income tax returns.
Over a three-decade investment horizon, the money lost to those taxes could reduce a foreign-stock fund's final value by 5 percent, research by David Musto, a finance professor at the University of Pennsylvania's Wharton School, and others showed in 2003.
"This is a reason to tilt away from dividend-paying foreign stocks in retirement savings," Musto said.
Still, depending on an individual investor's situation, the diversification benefits of owning international stocks might outweigh the tax drag, he said.
Meanwhile, others don't really see it as a drag. Because the foreign tax credit only eliminates double taxation in regular taxable accounts, an investor ends up paying the taxes on foreign dividends no matter which type of account contains them.
And depending on the stock or fund, the tax can be small, said Greg Rosica, an Ernst & Young tax partner in Tampa, Fla.
Some funds engage in dividend arbitrage and other strategies to keep dividends low as a tax-management strategy, while others with more of an income-generating mission keep them high. Dividend yields are found in fund literature, including the prospectus, and you can rank and compare them among funds using data services such as Morningstar Inc.
But the significant gap between the typically lower capital-gains tax rates, which affect taxable stock accounts, and ordinary income rates, which ultimately affect most retirement accounts, is perhaps a more important factor, said Mark Luscombe, principal federal tax analyst with CCH Inc., a Riverwoods, Ill., tax information publisher.
You can search out the low-yielding stocks and funds for retirement accounts, but don't let the proverbial tax tail wag the dog, said Richard Schroeder, a financial planner with Schroeder, Braxton & Vogt Inc. in Amherst, N.Y.
Schroeder looks for tax-managed mutual funds with a value tilt and prefers low-cost index funds for a big part of his client portfolios. When it comes to international exposure, however, he does use some more-actively managed funds. International funds typically account for up to 25 percent of clients' portfolios, and he often uses retirement accounts to store the more-actively managed international funds to avoid the capital gains associated with higher-turnover funds.
The ultimate answer might be to avoid an all-or-nothing strategy.
A core international position in low-dividend retirement accounts is probably smart, but there's a case to keep a few options open, said Duncan Richardson, chief equity strategist for Eaton Vance Corp. of Boston.
"Emerging markets is a good example," he said. "In a taxable account, you can harvest losses over time. In a qualified plan, you'll defer gains, but ultimately you may not end up in a much lower bracket in retirement. So you may achieve tax deferral but not tax minimization."
yourmoney@tribune.com
Janet Kidd Stewart writes for Tribune Media Services.