For many investors, diversifying their portfolios now means investing in stocks, shares, and funds outside the United States. That’s as true for investors managing a Roth individual retirement account (Roth IRA) as any other kind of portfolio. For these investors, foreign dividend stocks might look particularly attractive—especially since dividend stocks are regarded as some of the best types of investments to hold in a Roth IRA.
First, the good news: Nothing is stopping you from holding foreign dividend stock in your Roth IRA. The bad news: A number of factors can make holding this stock in an IRA very complicated. These include the way that tax works for foreign stock; the impact of currency fluctuations; and the accounting rules that you will be subject to.
That’s not to say that investing in foreign dividend stock through your Roth IRA is a bad idea—just that you need to be aware of a number of pitfalls before you do so. In this article, we’ll take you through them.
- Foreign dividend stock investing can be a good way to diversify your Roth individual retirement account (Roth IRA) portfolio while increasing exposure to foreign markets.
- Investing in international stocks can be more complicated than investing in domestic stocks.
- You might have to pay tax on foreign dividend income.
- You might need to factor in the impact of exchange rates on the value of your portfolio.
- Accounting and reporting requirements vary widely around the globe.
- Investing in foreign dividend stock means that you should research and possibly consult an expert.
Investing in Foreign Dividend Stock in a Roth IRA
First, the basics. Nothing in the Roth IRA rules limits your investments to the U.S., and investing in foreign stock can be an effective strategy. A long-term portfolio that includes a global stock index fund provides exposure to the broader world economy and lessens exposure to the U.S. economy in particular. Inexpensive funds that track an index like the MSCI ACWI (Morgan Stanley Capital International All Country World Index) Ex-U.S. or the EAFE (Europe, Australasia, Far East) Index provide broad geographical diversification at a relatively low cost.
Similarly, dividend stock is generally a good option for both traditional and Roth IRAs. This is because the Internal Revenue Service (IRS) normally requires you to pay taxes on dividend income; thus, the tax advantages of accounts like IRAs are maximized when you invest in stocks that generate otherwise taxable income.
As a result of these two factors, many investors may be tempted to add foreign dividend stocks to their Roth IRA portfolio. Doing so is now easier than ever before, thanks to advances in technology that make buying foreign stock as easy as investing in the U.S. However, the ease of buying foreign dividend stock can hide some of the complexities with holding this kind of stock.
In other words, you need to be aware of a few important factors before you add foreign dividend stock to your Roth IRA.
Countries withhold tax at different rates on dividends for foreign investors. If this rate is above zero, then it will lower your dividend payout. This is the same whether you hold dividend stock in a Roth IRA or a standard brokerage account.
You May Pay Tax on Foreign Dividend Stock
The tax implications of owning foreign dividend stock can be complex. Every country has its own tax laws, and they can vary dramatically from one government to the next. Many countries have no capital gains tax at all or waive it for foreign investors. But plenty do. Italy, for example, takes 26% of whatever proceeds a nonresident makes from selling their stock. Spain withholds 19% of such gains. The tax treatment of dividend and interest income runs the gamut as well.
Also, these aren’t the only taxes that you’ll have to pay, because the IRS normally requires you to pay taxes on dividend income as well. To avoid double taxation, tax treaties allow U.S. investors to recoup some or all of the taxes that they pay on assets held in taxable accounts. Such amounts are reflected on Form 1099-DIV, in Box 7 (“Foreign tax paid”).
However, this is where things get tricky for Roth IRAs. Because none of your IRA activities is reported as part of your tax return, you can’t claim either a foreign tax credit or deduction for your Roth IRA investments. In practice, this means that you will be taxed by the country you are investing in, and this will reduce some of the tax reduction benefits of your IRA.
How much tax you will pay depends on a wide variety of factors. Some countries don’t withhold dividend taxes from foreign investors (e.g., the United Kingdom), and some withhold significantly more (30% in France, for example). To make matters even more complicated, even different classes of the same stock, offered by the same company, can have different taxes applied to their dividends.
Calculating how much tax you owe can be complicated, which is one reason why it’s advisable to consult an expert before investing in foreign dividend stocks. But here’s the bottom line: As long as the dividend tax withholding rate is above zero, the taxes withheld by the foreign government will reduce your dividend payout, whether you hold the stock in an IRA or elsewhere.
Currency Fluctuations May Affect Your Returns
Second, you should keep in mind that by investing in foreign stock, you are holding part of the value of your portfolio in a foreign currency. This means that fluctuations in the exchange rate between the U.S. dollar and the other currency can affect the value of your stock and the effective value of your dividends. If the value of the second currency decreases against the dollar, this will reduce the value of your portfolio.
This is a risk with any form of overseas investment, of course, but it’s particularly pronounced when it comes to long-term investments like IRAs. This is because there can be long-term trends in the value of one currency against another, and they can be large enough to wipe out price rises in individual stocks (and even whole stock markets). For example, the pound sterling (GBP) has been losing value against the dollar for most of the last century. In other words, the value of one currency against another doesn’t tend to even out over time—instead, the strength of a currency may reflect decades-long trends in the success (or otherwise) of a particular country.
There are also short-term but potentially catastrophic risks associated with foreign investments. In the event of a war, for instance, foreign countries can decide to nationalize foreign-owned assets—stripping U.S. investors of their stocks. If you are relying on these stocks for your retirement, such an action could have a huge impact.
Accounting and Reporting Rules Can Be Different
Finally, you should know that accounting and reporting rules also differ around the world. This can make working with foreign stock difficult, even for experts. Each country has its own tax system, and companies are required to report their earnings in a different way in each.
In Mexico, for example, the balance sheet, income statement, and cash flow statement are adjusted for past inflation rates as a result of the high inflation that the country’s economy has suffered. This allows investors to get an idea of what is going on with an enterprise after stripping out the effects of the currency. This principle is significantly different than the one used in the U.S., where a company might show a 4% “increase” in profits on their balance sheets if inflation stands at 4% in a given year.
Such is the variation in accounting and reporting rules, in fact, that it can be difficult to ascertain the actual value of the stock. And that problem is only compounded by the other factors that we’ve mentioned above, such as exchange rate fluctuations and tax implications.
Can I hold foreign dividend stock in my Roth individual retirement account (Roth IRA)?
Yes. You can hold a wide variety of assets in your Roth individual retirement account (Roth IRA), and there are no rules against holding foreign dividend stock as part of your Roth IRA portfolio.
Is it wise to put foreign dividend stocks in a Roth IRA?
It depends on many factors. Foreign dividend stocks can be a good way to diversify your Roth IRA portfolio. However, you should make sure that you understand the tax implications of investing in these stocks, and take into account exchange rate fluctuations when calculating their value.
Do I pay taxes on foreign dividends in my Roth IRA?
Again, it depends. The dividends that you receive on investments in your Roth IRA are not normally taxed. However, if you invest overseas, then the country where the stock is held may withhold tax on your dividend income. And because you don’t report IRA activity to the Internal Revenue Service (IRS), you will not be able to claim a foreign tax credit to offset this.
The Bottom Line
Investing in foreign dividend stock as part of your Roth IRA portfolio can be a good way to increase your diversification as well as your exposure to foreign markets. However, international investment can be much more complicated than domestic investment.
There are a number of key factors to keep in mind if you want to add foreign dividend stocks to your Roth IRA portfolio. These include the fact that you might have to pay tax on foreign dividend income; the impact of exchange rates on the value of your portfolio; and widely varying accounting and reporting requirements around the world.
None of these factors means that investing in foreign dividend stock is a bad idea. But they do mean that you should do plenty of research, and ideally consult an expert, before investing significant sums in this kind of stock.