California Residents: ExUS Investments in Taxable vs Tax Advantaged Accounts

[Cranberry44]

California does not recognize the foreign tax credit (anyone know why?). Does this mean that all things considered equal, California residents should only hold international stocks/ETFs/Mutual Funds, etc. in a tax advantaged account?

[Beensabu]

Because state sovereignty.

If it makes you feel any better, it turns out holding certain exUS equity funds in tax-advantaged accounts is better even with the federal foreign tax credit - it just depends on yield and % of qualified dividends.

[retired@50]

California does not recognize the foreign tax credit (anyone know why?). Does this mean that all things considered equal, California residents should only hold international stocks/ETFs/Mutual Funds, etc. in a tax advantaged account?

IF you hold a small-ish position in international stock index, then you'll get to deduct the full amount of foreign taxes paid.

See the "exception" note in the wiki page: https://www.bogleheads.org/wiki/Foreign_tax_credit

Keeping your position to less than $125,000 single, or $250,000 MFJ and you'll get the full benefit on your Federal taxes. I'd ignore the state tax issue in this case, but I could be wrong here...???

Regards,

[grabiner]

.

The reason it is often better for CA residents to hold US stocks in taxable and foreign stocks in tax-advantaged is that foreign stocks have higher dividend yields. Here is my standard example:

US stock fund has a 2% dividend yield, all qualified.
Foreign stock fund has a 3% dividend yield, 2/3 qualified, but with 8% of the dividend (0.24% total) withheld as foreign tax.

In a 24% tax bracket, both funds have a 0.30% tax cost. The foreign fund has an extra 0.24% tax on the non-qualified dividend, which is equal to the foreign tax credit. Thus, in a no-tax state, you would be indifferent between the two funds in a taxable account.

But in a 9.3% CA tax bracket, the CA tax on the US fund is 0.19%, and on the foreign fund is 0.28%, so the foreign fund has a slightly higher tax cost.

As for the "why" there is no foreign tax credit: very few states allow a foreign tax credit. The logic is that the credit is intended to mitigate double taxation, and there is no double taxation here. If you pay tax to France on your French stocks, you take a credit against that on your US tax, so your total US+France tax is the same as if you didn't owe tax to France. Adding state tax doesn't change this; you are still no worse off because your stock was foreign.

Conversely, CA, like all other states with an income tax, offers a credit for tax paid to other states. If you are a CA resident and work in NY, you take a credit against your CA tax for the tax you paid to NY on the same income. Again, this mitigates the double taxation

[Cranberry44]

The reason it is often better for CA residents to hold US stocks in taxable and foreign stocks in tax-advantaged is that foreign stocks have higher dividend yields. Here is my standard example:

US stock fund has a 2% dividend yield, all qualified.
Foreign stock fund has a 3% dividend yield, 2/3 qualified, but with 8% of the dividend (0.24% total) withheld as foreign tax.

In a 24% tax bracket, both funds have a 0.30% tax cost. The foreign fund has an extra 0.24% tax on the non-qualified dividend, which is equal to the foreign tax credit. Thus, in a no-tax state, you would be indifferent between the two funds in a taxable account.

But in a 9.3% CA tax bracket, the CA tax on the US fund is 0.19%, and on the foreign fund is 0.28%, so the foreign fund has a slightly higher tax cost.

As for the "why" there is no foreign tax credit: very few states allow a foreign tax credit. The logic is that the credit is intended to mitigate double taxation, and there is no double taxation here. If you pay tax to France on your French stocks, you take a credit against that on your US tax, so your total US+France tax is the same as if you didn't owe tax to France. Adding state tax doesn't change this; you are still no worse off because your stock was foreign.

Conversely, CA, like all other states with an income tax, offers a credit for tax paid to other states. If you are a CA resident and work in NY, you take a credit against your CA tax for the tax you paid to NY on the same income. Again, this mitigates the double taxation

I asked ChatGPT to help me understand, using your standard example, but with VTI and VXUS with 1k in each.


"To calculate the tax impact of these two funds, VTI (US stock fund) and VXUS (foreign stock fund), we'll break down the calculations based on the given information. We'll use the dividend yields, the tax rates, and the foreign tax credit to determine the tax costs for each fund.

1. US Stock Fund (VTI)
Dividend Yield: 2% of $1,000 = $20
Tax Rate: 24%
Tax Cost: 24% of $20 = $4.80
State Tax (CA 9.3%): 9.3% of $20 = $1.86
Total Tax Cost: $4.80 (federal) + $1.86 (state) = $6.66
Tax Cost as a Percentage of Investment: $6.66 / $1,000 = 0.666%

2. Foreign Stock Fund (VXUS)
Dividend Yield: 3% of $1,000 = $30
Qualified Dividend: 2/3 of $30 = $20 (qualified at 15% federal tax rate)
Non-Qualified Dividend: 1/3 of $30 = $10
Foreign Tax Withheld: 8% of $30 = $2.40
Federal Tax on Qualified Dividend: 15% of $20 = $3
Federal Tax on Non-Qualified Dividend: 24% of $10 = $2.40
State Tax (CA 9.3%): 9.3% of $30 = $2.79
Total Tax Cost: $3 (federal qualified) + $2.40 (federal non-qualified) + $2.79 (state) - $2.40 (foreign tax credit) = $5.79
Tax Cost as a Percentage of Investment: $5.79 / $1,000 = 0.579%

Comparison
US Fund (VTI): 0.666% total tax cost
Foreign Fund (VXUS): 0.579% total tax cost

Based on this calculation, the foreign fund (VXUS) has a slightly lower tax cost compared to the US fund (VTI) when considering both federal and state taxes, despite the foreign tax withholding."

This seems to not land at the same conclusion. Is there a mistake here?

[Jacotus]

The reason it is often better for CA residents to hold US stocks in taxable and foreign stocks in tax-advantaged is that foreign stocks have higher dividend yields. Here is my standard example:

US stock fund has a 2% dividend yield, all qualified.
Foreign stock fund has a 3% dividend yield, 2/3 qualified, but with 8% of the dividend (0.24% total) withheld as foreign tax.

In a 24% tax bracket, both funds have a 0.30% tax cost. The foreign fund has an extra 0.24% tax on the non-qualified dividend, which is equal to the foreign tax credit. Thus, in a no-tax state, you would be indifferent between the two funds in a taxable account.

But in a 9.3% CA tax bracket, the CA tax on the US fund is 0.19%, and on the foreign fund is 0.28%, so the foreign fund has a slightly higher tax cost.

As for the "why" there is no foreign tax credit: very few states allow a foreign tax credit. The logic is that the credit is intended to mitigate double taxation, and there is no double taxation here. If you pay tax to France on your French stocks, you take a credit against that on your US tax, so your total US+France tax is the same as if you didn't owe tax to France. Adding state tax doesn't change this; you are still no worse off because your stock was foreign.

Conversely, CA, like all other states with an income tax, offers a credit for tax paid to other states. If you are a CA resident and work in NY, you take a credit against your CA tax for the tax you paid to NY on the same income. Again, this mitigates the double taxation

I asked ChatGPT to help me understand, using your standard example, but with VTI and VXUS with 1k in each.
...

This seems to not land at the same conclusion. Is there a mistake here?

ChatGPT does not actually understand anything, and it is well known that it will come to wrong conclusions with highly intricate mathematical and/or detail-oriented calculations.

You have been given a very good explanation from an extremely knowledgeable person. ChatGPT isn't even close to being in the same league. My advice: don't ignore the good advice from the expert and run to a chatbot.

[toddthebod]

1. US Stock Fund (VTI)
Dividend Yield: 2% of $1,000 = $20
Tax Rate: 24%
Tax Cost: 24% of $20 = $4.80
State Tax (CA 9.3%): 9.3% of $20 = $1.86
Total Tax Cost: $4.80 (federal) + $1.86 (state) = $6.66
Tax Cost as a Percentage of Investment: $6.66 / $1,000 = 0.666%

This seems to not land at the same conclusion. Is there a mistake here?

VTI dividends are qualified.

[Cranberry44]

I asked ChatGPT to help me understand, using your standard example, but with VTI and VXUS with 1k in each.
...

This seems to not land at the same conclusion. Is there a mistake here?

ChatGPT does not actually understand anything, and it is well known that it will come to wrong conclusions with highly intricate mathematical and/or detail-oriented calculations.

You have been given a very good explanation from an extremely knowledgeable person. ChatGPT isn't even close to being in the same league. My advice: don't ignore the good advice from the expert and run to a chatbot.

You're absolutely right -- I meant no disrespect. I don't feel that I'm ignoring the experts advice, but I am looking to understand myself, and I'm not quite there yet.

[Cranberry44]

VTI dividends are qualified.

Thanks -- that may be the mistake... or perhaps one of many?

I told ChatGPT that VIT dividend are qualified and here was the response:

Got it. Since the dividends from VTI (US stock fund) are all qualified, we need to adjust the tax calculations accordingly. Qualified dividends are taxed at a lower rate than ordinary income, so this will affect the total tax cost.

Revised Calculations

1. US Stock Fund (VTI)
Dividend Yield: 2% of $1,000 = $20
Qualified Dividends Tax Rate: 15% (assuming 24% tax bracket)
Federal Tax Cost: 15% of $20 = $3
State Tax (CA 9.3%): 9.3% of $20 = $1.86
Total Tax Cost: $3 (federal) + $1.86 (state) = $4.86
Tax Cost as a Percentage of Investment: $4.86 / $1,000 = 0.486%

2. Foreign Stock Fund (VXUS)
Dividend Yield: 3% of $1,000 = $30
Qualified Dividend (2/3 of Total): 2/3 of $30 = $20 (qualified at 15% federal tax rate)
Non-Qualified Dividend (1/3 of Total): 1/3 of $30 = $10
Foreign Tax Withheld: 8% of $30 = $2.40
Federal Tax on Qualified Dividend: 15% of $20 = $3
Federal Tax on Non-Qualified Dividend: 24% of $10 = $2.40
State Tax (CA 9.3%): 9.3% of $30 = $2.79
Total Tax Cost: $3 (federal qualified) + $2.40 (federal non-qualified) + $2.79 (state) - $2.40 (foreign tax credit) = $5.79
Tax Cost as a Percentage of Investment: $5.79 / $1,000 = 0.579%

Comparison
US Fund (VTI): 0.486% total tax cost
Foreign Fund (VXUS): 0.579% total tax cost
With these revised calculations, the US stock fund (VTI) has a lower tax cost than the foreign stock fund (VXUS) in a 9.3% California tax bracket.

[Jacotus]

I asked ChatGPT to help me understand, using your standard example, but with VTI and VXUS with 1k in each.
...

This seems to not land at the same conclusion. Is there a mistake here?

ChatGPT does not actually understand anything, and it is well known that it will come to wrong conclusions with highly intricate mathematical and/or detail-oriented calculations.

You have been given a very good explanation from an extremely knowledgeable person. ChatGPT isn't even close to being in the same league. My advice: don't ignore the good advice from the expert and run to a chatbot.

You're absolutely right -- I meant no disrespect. I don't feel that I'm ignoring the experts advice, but I am looking to understand myself, and I'm not quite there yet.

Thanks for saying so. Trying to piece apart ChatGPT's outputs can be fun, but I wouldn't trust it for financial accounting. Just be careful because even when you tell it about a mistake, it can say it has corrected it but sometimes not actually do so.