International Stocks & The Foreign Tax Credit: The Asset Location Strategy No One Talks About
International Stocks & The Foreign Tax Credit: The Asset Location Strategy No One Talks About
CORE INSIGHTS
- The Double Tax Trap: Holding international funds (like VXUS) in an IRA leads to double taxation. The foreign tax is lost forever.
- The Taxable Advantage: In a Taxable Account, you can claim the Foreign Tax Credit (FTC), getting a dollar-for-dollar reduction in your US taxes.
- Net Yield Boost: This strategy boosts after-tax returns by ~0.25% annually. It’s “free money” for proper placement.
Asset Allocation tells you to diversify globally. Asset Location tells you where to put it. International Equities pay taxes to foreign governments first. If held in an IRA, that money vaporizes. If held in a taxable account, the IRS gives you a refund.
What-If Scenario: The Missing $300
| Scenario | Foreign Tax Withheld | Net Result |
|---|---|---|
| IRA (Trap) | -$300 | $300 Loss (Unrecoverable) |
| Taxable (Smart) | -$300 | $0 Loss (Offset by $300 Credit) |
Visualizing the “Lost Yield”
*Figure 1: Yield Comparison. The IRA holding suffers a permanent ‘Foreign Tax Drag’.*
Strategic Action Steps
Check your portfolio. Are you holding VXUS/IXUS in your IRA while holding VTI in taxable? If so, you are inefficient.
Sell US stocks in Taxable to buy International. Simultaneously, sell International in IRA to buy US stocks. Keep your overall allocation percentage same.
At tax time, look for “Foreign Tax Paid” on your 1099-DIV. Enter this amount on IRS Schedule 3 to claim your credit.
The Bottom Line: Who Should Choose What?
- Maximize FTC: Investors with significant taxable brokerage assets should fill the taxable bucket with International Funds first.
- Ignore FTC: Investors whose entire net worth is in 401(k)s and IRAs. You cannot use this strategy.
Frequently Asked Questions
Why is holding International Stocks in an IRA bad?
When international funds pay dividends, foreign governments withhold taxes. In an IRA, you cannot claim the Foreign Tax Credit to recoup this cost.
How much is the Foreign Tax Credit worth?
It typically boosts after-tax returns by 0.20% to 0.30% per year. For a $100k allocation, that’s $200-$300 of free money.
Do I need to file extra forms?
If foreign taxes are under $300 (Single) or $600 (Joint), you claim it directly on Schedule 3 without Form 1116. If higher, Form 1116 is required.