Cashing In on Foreign Stocks

 In Stocks

Many investors who seek income are turning to dividend paying stocks. While bank accounts and money market funds pay meager amounts, the dividend yield on the S&P 500 is around 2%. That’s the average yield, so many established companies are paying 3%, 4%, or even more to shareholders. Moreover, stock market investors have the potential for future growth and, as explained later in this article, typically receive favorable tax treatment on dividend income.
If the idea of investing in dividend paying stocks appeals to you, consider allocating a portion of your portfolio to foreign stocks that make such payouts to shareholders. The benchmark Morgan Stanley Capital International (MSCI) EAFE Index, which tracks the performance of large companies based in Europe, Australasia, and the Far East, has a dividend yield over 3%, as of this writing. Thus, foreign stocks not only can diversify your portfolio, they may offer dividends higher than the yields on U.S. issues.
U.S. investors who want to invest in foreign stocks have several options. You can invest in American Depositary Receipts (ADRs), for example. ADRs, which represent ownership of equity shares in a foreign company, trade on U.S. exchanges or over-the-counter, so you can buy or sell them as you would with domestic stocks. Rather than buying individual foreign issues, you can invest in a fund holding foreign stocks. Choices include familiar mutual funds; closed-end funds, which trade on a stock exchange between investors; and exchange- traded funds (ETFs), which track a specific stock index.
Tax traps
Selected carefully, dividend paying foreign stocks and funds that hold such issues may play a valuable role in a diversified portfolio. However, you should be aware of two tax issues these investments may raise.

Dividends may not qualify for low tax rates.
As explained in the April 2013 CPA Client Bulletin, qualified dividends enjoy favorable tax rates. Most investors pay 15% tax on such dividends, whereas high and low bracket investors pay 20% and 0%, respectively. On dividends that are not qualified, though, investors pay tax at higher rates, ranging from 10% to 39.6%.
Typically, dividends from ADRs qualify for the low tax rates. Similarly, dividends from companies based in countries that have specific types of tax treaties with the U.S. also can qualify. Not all foreign stock dividends are from such countries, though. If you invest in a fund that receives nonqualified dividends from the stocks it owns, some of your dividend income may be taxed at high, ordinary tax rates, rather than the lower rate on qualified dividends.
Foreign tax withholding can reduce your yield. When foreign companies pay dividends to investors from other countries, some money may be withheld to cover the income tax obligation to the host country. The amount of withholding varies from country
to country, depending on factors such as local law, tax treaties with the United States, and whether the stock is held in an IRA.
Example: Luke Miller invests in ADR shares that pay a dividend equivalent to $1,000 in U.S. dollars in 2013. The company represented by the ADR is based in a country that requires 15% withholding on dividends paid to U.S. investors. Thus, Luke receives $850 in dividend income in 2013 from that ADR, after $150 of withholding. If the posted yield on that stock is 5%, Luke actually receives the equivalent of a 4.25% dividend.
Foreign stock funds also withhold dividends in this manner. If your foreign stock or fund dividend income is subject to withholding, you may be able to get some IRS relief. One approach is to deduct the amount withheld (and thus paid to a foreign government) as an itemized deduction on Schedule A of your tax return. You can include such foreign taxes along with other deductible tax payments.
However, you’ll receive only partial tax relief from an itemized deduction. If Luke is in a 28% tax bracket, for instance, a $150 deduction for foreign taxes paid saves him only $42 in tax: 28% of $150. Also, high-income taxpayers might lose some tax benefits under a new law that devalues some itemized deductions.
Taking credit
Instead of deducting the foreign tax you’ve paid, you may prefer to claim a credit for those taxes. (See the “Credit Check” Trusted Advice column for more information.) Generally, for foreign tax paid up to $300 ($600 for married couples filing a joint tax return), you can claim the credit on your Form 1040 tax return. Luke Miller, for example, could use the tactic to reduce his tax bill by the $150 of foreign dividends withheld from his investment income.
If you have a larger amount of foreign dividends withheld in a given year, you generally must file IRS Form 1116 to claim a tax credit. This form can be complex, but our office can help you provide the information necessary to get the credit.
Unfortunately, neither the tax credit nor the itemized deduction for foreign taxes paid will help if you hold your dividend-paying foreign stocks in a tax-deferred retirement account, such as an IRA. Luke, in our example, would wind up with a 4.25% dividend yield, not a 5% yield, if he holds his ADR in an IRA.
If the dividends you receive are qualified dividends, you may prefer to hold foreign dividend paying stocks in a taxable account. You’ll be able to use the low tax rates on qualified dividends, and you can take a deduction or a tax credit to address the impact of any foreign tax withholding.