International in taxable - confused about something

[airofft]

I've read here for a while that it's best to put International funds in taxable accounts because of the foreign tax credit. Since some foreign funds yield ~3% (ex. FTSE All-World ex-US (VEU) and FTSE All-World Small Cap ex-US (VSS)), wouldn't you want them in your Roth or Traditional IRAs so you wouldn't be paying taxes on the 3% you get from dividends?

[livesoft]

It's a dance.

Foreign governments tax the dividends paid by company stocks held in VEU and VSS, so owners of funds like VEU and VSS do not get the full dividend because of those taxes that are removed before they get the dividend. So in a Roth or tax-advantaged account, one pays taxes on dividends, but not to the US federal government.

One can claim most of the taxes paid to a foreign government as a credit on their US tax return because the US laws generally are against double-taxation. So take your poison: Pay foreign taxes and pay no US taxes -or- Pay foreign taxes, get a credit for them and pay US taxes.

And of course if folks don't claim the foreign tax credit for their taxable holdings that paid foreign taxes, then they pay both foreign taxes and US taxes on their dividends.

[House Blend]

Yes, it's a dance, but the OP right to be confused. The foreign tax credit is a lesser consideration when there is a big spread between domestic and foreign dividends.

Here's an example calculation with IMO realistic numbers. We'll assume that we have plenty of tax-advantaged space and have the option of hitting our allocation targets while holding either 100% TSM or 100% International in our taxable account.

So we want to pick whichever one bleeds less in taxes.

Suppose the taxable account holds $10,000. (So $1 = 1 basis point.)

We want to look at an example of a big spread, so let's say that TSM yields 2% and International yields 3%. Foreign taxes are typically about 7% of the dividend, so to get a 3% yield really means 3.23% with 0.23% foreign taxes withheld.

Suppose we are in the 25% + 5% Federal + State tax brackets.

We are on the cusp of big potential changes in the taxation of dividends, one where qualified dividends exist and are taxed at 15% (or 0%), and another where they are taxed as ordinary income. So I'll run two examples.

Example 1: Qualified dividends.
(a) TSM: generates $200 in dividends, 100% qualified.
Total taxes due: $40 = $30 Fed + $10 State.
(b) Intl: generates $323 in dividends, 70% qualified (this is typical).
Total taxes due: $51 = $58 Fed + $16 State - $23 FTC

TSM wins by 11bp.

Example 2: No qualified dividends.
(a) TSM generates $200 in dividends, none qualified.
Total taxes due: $60 = $50 Fed + $10 State.
(b) Intl generates $323 in dividends, including $23 in foreign taxes.
Total taxes due: $74 = $81 Fed + $16 State - $23 FTC

TSM wins by 14bp.

The conclusions I draw from this calculation are:

1. If foreign yields are significantly higher, you are better off holding TSM in a taxable account. How much higher is going to depend on your tax brackets and the laws governing the taxation of dividends.

2. The order of magnitude of the effect (using recent yields and recent tax rates) is small, comparable to the difference between holding Admiral Shares and Investor Shares.

If you are confident that this spread is going to be large for the foreseeable future, then go ahead and put TSM in taxable. What I've noticed in recent years while I've been paying attention is that the dividend yields and the spreads are quite variable.

P.S. Welcome to the forum, airofft.