Investors in foreign stock funds need to consider the foreign tax credit in both fund choice and asset allocation decisions. But the importance of the credit depends on the decision the investor is making.
Suppose Fund B has a higher foreign tax credit than Fund A. What decision are you making between the funds?
You are going to hold Fund A and Fund B, one in taxable and one in tax-advantaged. The foreign tax credit reduces the tax cost of Fund B, and therefore favors Fund B in taxable, although this must be considered together with other tax issues such as dividend yields and qualified dividends. (The higher dividend yields and more non-qualified dividends on foreign stocks often favor holding US stocks in taxable and foreign stocks in tax-deferred.)
You are going to hold only one of Fund A or Fund B, in a tax-advantaged account. The foreign tax credit is lost, so this favors Fund A; you will get closer to the return on the fund's investments by holding Fund A.
You are going to hold only one of Fund A or Fund B, in a taxable account. The foreign tax credit is neutral. With either fund, your returns will lag the returns on the fund's investments by the dividend tax. The foreign tax credit is withheld, but you will (usually) get it all back. You should favor whichever fund has lower dividend tax and expenses.
Here is a numerical example. Funds A and B both hold stocks with a 3% dividend yield, 2/3 qualified. Fund A has 5% of the dividend withheld as foreign tax, while Fund B has 10%.
In a tax-advantaged account, you receive a 2.85% dividend on Fund A, lagging the stock returns by 0.15%. You receive a 2.70% dividend on Fund B, lagging the stock returns by 0.30%.
In a taxable account, you get the full 3% dividend on either fund, as the 0.15% or 0.30% is returned as a foreign tax credit. In a 24% tax bracket, you then pay 0.30% tax on the 2% qualified dividend, and 0.24% on the 1% non-qualified dividend, so both funds lag the stock returns by 0.54%.
So you would prefer Fund A in tax-advantaged if you will hold only one fund, with no preference in taxable, and would prefer A in tax-advantaged and B in taxable if you will hold both and are choosing which one goes into a taxable account.
Suppose Fund B has a higher foreign tax credit than Fund A. What decision are you making between the funds?
You are going to hold Fund A and Fund B, one in taxable and one in tax-advantaged. The foreign tax credit reduces the tax cost of Fund B, and therefore favors Fund B in taxable, although this must be considered together with other tax issues such as dividend yields and qualified dividends. (The higher dividend yields and more non-qualified dividends on foreign stocks often favor holding US stocks in taxable and foreign stocks in tax-deferred.)
You are going to hold only one of Fund A or Fund B, in a tax-advantaged account. The foreign tax credit is lost, so this favors Fund A; you will get closer to the return on the fund's investments by holding Fund A.
You are going to hold only one of Fund A or Fund B, in a taxable account. The foreign tax credit is neutral. With either fund, your returns will lag the returns on the fund's investments by the dividend tax. The foreign tax credit is withheld, but you will (usually) get it all back. You should favor whichever fund has lower dividend tax and expenses.
Here is a numerical example. Funds A and B both hold stocks with a 3% dividend yield, 2/3 qualified. Fund A has 5% of the dividend withheld as foreign tax, while Fund B has 10%.
In a tax-advantaged account, you receive a 2.85% dividend on Fund A, lagging the stock returns by 0.15%. You receive a 2.70% dividend on Fund B, lagging the stock returns by 0.30%.
In a taxable account, you get the full 3% dividend on either fund, as the 0.15% or 0.30% is returned as a foreign tax credit. In a 24% tax bracket, you then pay 0.30% tax on the 2% qualified dividend, and 0.24% on the 1% non-qualified dividend, so both funds lag the stock returns by 0.54%.
So you would prefer Fund A in tax-advantaged if you will hold only one fund, with no preference in taxable, and would prefer A in tax-advantaged and B in taxable if you will hold both and are choosing which one goes into a taxable account.
Statistics: Posted by grabiner — Wed Jan 29, 2025 7:41 pm — Replies 0 — Views 39