Is it best to hold international stocks in a taxable or tax deferred account?
Posted on April 5, 2024

This was an interesting article at Morningstar: Should You Keep Foreign Stocks Out of Your IRA? Tax considerations suggest yes…. There is an added tax wrinkle with international stocks or funds, but I conclude the opposite: the tax considerations CLEARLY say it’s preferable to hold your international funds in a Roth or Traditional IRA account. You earn about 6.0% after-tax return when international is held in your taxable account, and you earn about 6.8% after-tax return when it’s held in your IRA.

 

• Details of two tax wrinkles:

 

== Foreign taxes paid ==

 

In your taxable account, you pay a 15% tax on all dividends you receive from your taxable stock funds (FSKAX and VXUS in our case). Some of the taxes that you pay are to foreign countries. So that you are not double-taxed, you get a direct tax credit (deduction) on US taxes for “foreign taxes paid” shown in box 7 of your 1099-DIV.

 

You don’t pay tax on dividends for securities held in your IRA, but YOU DO NOT GET BACK the taxes you’ve paid foreign countries. The total return (price + the effect of dividends reinvested) is LESS in an IRA than a taxable account because of the lower net dividends you have to reinvest. I calculate the effect is about 0.3% less in total return per year.

 

 

== High dividend rate on International ==

 

The dividend yield on international stocks is about 3.1%. You are paying taxes each year on dividends in your taxable account. You are compounding a slightly smaller top-line amount each year than you would if you paid no taxes on the dividend. The lower top-line growth is not offset by your higher cost basis. You net less over time, and you net less from a greater dividend rate.

 

It requires a spreadsheet to figure out the effect of paying taxes on dividends: for 7.1% real return and 1.3% dividends year, an investment held 25 years in a retirement account results in about 16% more than an investment in a taxable account. I show here the first few years of my spreadsheet that tracks the difference in return for an investment in a taxable account and a retirement account.

 

== I compare the two ==

 

I use my spreadsheet to compare the after-tax return from international fund held in a Taxable vs. IRA account, but I don’t need a spreadsheet to reach the conclusion that an investment in an IRA is better than one held in a taxable account.

 

• Taxable effectively knocks off 15% of the growth of an investment from taxes on dividends and on the ultimate gain when sold. The 15% isn’t a direct reduction in the return rate, but it’s simplest to think that you are lowering a 7.1% pre-tax return rate about 6.0% after-tax return rate.

 

• The investment in an international fund has about 0.3% knocked off a 7.1% annual return rate because of the “lost” foreign taxes: net of about 6.8% after tax return rate.

 

My spreadsheet shows a dollar advantage to holding your investment in a retirement account in all years.  The relative dollar  benefit increases with time.

 

 

 

Conclusion: Some suggest you should hold an investment in an international fund, like VXUS, in a taxable account and not in a retirement account. The argument is that your net return in a Retirement Account will be less because you lose foreign taxes paid.

 

The logic is straightforward, though. It clearly makes sense to hold your international stocks in your retirment account.

 

• Your after-tax return rate on a taxable investment is less because of the 15% gains tax. A 7.1% pre-tax return rate is about 6.0% after-tax rate.

 

•  Your after-tax return rate on international stocks in your IRA is about 0.3% less from the lost foreign taxes paid. It’s about a 6.8% after-tax return rate.

 

The dollar benefit is small in early years but grows over time.