The cost of foreign taxes on returns

In February, Guindy Sam wrote about taxes on foreign dividends and taxes, and I decided to quantify the issue using data from the index provider MSCI. Quick reminder: some countries tax dividends at the source when they're paid, similar to payroll withholding tax. US taxpayers can claim credit for these foreign taxes paid on their returns (the Foreign Tax Credit). But investors who do not itemize this benefit — those holding the stocks in IRAs, 401(k)s, or other non-taxable accounts — get no credit, so the tax becomes a permanent performance drag. MSCI publishes index returns both gross and net of withholding taxes, so we can compare the two to estimate the tax cost. As of May 29, the MSCI ACWI ex USA Index shows a 10-year net return of 9.82% versus a gross return of 10.36% — a difference of 54 bps. Looking year-by-year, the gap stays within a few bps of that figure, so it's a consistent drag rather than a one-off. That's not a trivial difference. Owning foreign stocks in taxable account gives you the ability to take a tax credit when you file your return though it's partly offset by the generally higher dividend yields foreign stocks pay versus US stocks. Readers should evaluate their own tax situation including IRMA calculations, but the bottom line: expect roughly 50 bps of additional annual cost if you hold foreign equities in a non-taxable account versus a taxable one. Quick tip: If you own foreign stocks directly, make sure that your brokerage is withholding the correct amount. I found two large firms withholding 25% when 15% was applicable.  I needed to file aform. Matt Halperin, CFA, is the founder of Act2 Financial, an app that helps seniors avoid financial fraud, particularly social engineering scams. For 30 years, he worked as a portfolio manager and risk manager at large U.S. money managers. Matt currently serves on the investment committee of two endowments.  He has a BA and MBA from the University of Chicago and resides outside of Boston.

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