How to Offset Taxes on International Stock Dividends

Despite their high payouts, international stocks and funds can come with big tax bills, but there are ways to offset those hefty levies.

There is no denying the appeal of foreign equities. The dividend yield on the stocks as of mid-September in the MSCI EAFE Index are more than 3%, while the average for stocks in the S&P 500 is under 2%.

“We see dividend-paying stocks outside the U.S. as being attractive now,” says Jonathan Brodsky, managing director of investment management firm Advisory Research in Chicago. “In addition, companies in Japan and Korea could be announcing meaningful increases in their dividend rates in the coming years. Governments there have indicated they will introduce measures to generate higher payouts to shareholders.”

TAX TRAPS

But there are potential tax traps.

“The home country may require companies to withhold some of the dividend for taxes before releasing the payments to foreign investors,” Brodsky says.

For example, if a foreign company pays a $1,000 dividend to an American shareholder and that company is based in a country that requires 15% withholding, the cash flowing to the investor would be just $850.

TAKING CREDIT

Fortunately, there are ways to offset those taxes that effectively have been paid to a foreign government, thus avoiding double taxation.

Here are a few:

Take an itemized deduction. This simple method delivers only a partial payoff. A $150 deduction, for instance, saves $60 in tax for a client whose effective marginal tax rate is 40%. In addition, high-bracket clients may lose some tax benefits from itemized deductions under a new tax law here.

Take a foreign tax credit on Form 1040. With a $150 tax credit, the tax savings is $150. However, taxpayers can take this easy step only if they have paid no more than $300 in foreign tax on dividends and interest ($600 for couples filing jointly). There are a few other hurdles to clear, too.

File IRS Form 1116. An individual who has paid more than $300 or $600 in foreign tax must file this form, which can be complicated, in order to claim the tax credit.

“With regard to foreign tax withheld, our clients generally take the tax credit,” says Martin James, a CPA/PFS president and managing member of Martin James Investment & Tax Management in Mooresville, Ind.

Michael Eisenberg, a CPA/PFS and founder of Eisenberg Financial Advisors in Los Angeles, agrees, adding that mutual fund companies and brokerage firms have been very good about reporting the foreign tax withheld, making it easier to prepare Form 1116. “These firms have been showing it on the year-end 1099 forms that report dividend and interest income so it is easy to spot and pick up,” he notes.

James points out that many taxpayers will take this credit for federal purposes and then forget to take it on their state income tax return, if the state allows, so advisors should follow up with clients who have foreign dividend income.