The Pitfalls of Global Investing Through a Roth IRA
Things To Consider If You Buy Foreign Investments
Over the past decade, advances in technology have made it possible to buy shares of stock in London or Tokyo almost as easily as you can buy an investment on the New York Stock Exchange. This is complicated enough when building a portfolio through a regular brokerage account, but the complexity is compounded when you are dealing with the tax and regulatory restrictions of a retirement plan. To help you navigate the international waters, here are some things you might want to consider if you take a global investing approach to your Roth IRA.
Dividend Tax Withholding Rates and Dual Share Classes
Many large international companies maintain dual listings in multiple countries. This allows global investors to select the one that is most beneficial for their own particular tax requirements because some countries withhold 0% in dividend taxes to foreign investors (e.g., the United Kingdom) and some withhold significantly more (e.g., 30% in France).
A perfect example is oil and natural gas giant, Royal Dutch Shell. The company has two classes of stock - Class A shares and Class B shares. The actual specifics are complicated and involve international tax treaties, but the bottom line is if you are an American citizen, you are probably going to do far better by owning the Class B shares because no dividend taxes will be withheld, resulting in far higher dividend yields.
To give specific numbers, based on the trading prices when I originally published this article in 2012, a $100,000 Roth IRA invested entirely in Royal Dutch Shell Class A shares would receive $4,700 in cash dividends per year. The same $100,000 Roth IRA invested in Royal Dutch Shell Class B shares would receive $5,300 in cash dividends per year.
That is an extra 12.77% cash return for owning what effectively amounts to the exact same assets. Given a few decades, as dividends were reinvested, the net difference in wealth between the Class A and Class B shareholders who held their stock through a Roth IRA would grow by multiples until the Class B shareholder had many, many times the total investment as the Class A shareholder.
If, in contrast, you had wanted to buy shares of Total, SA, the French oil giant, the same $100,000 would have generated $5,000 in dividend income but the French government would have taken $1,500 of that and sent your Roth IRA the remaining $3,500. If you had the stock held in a brokerage account, you could file a foreign tax credit with the IRS and recapture much of that money.
If the stock were held in your Roth IRA, you would be out of luck. That drops Total's dividend yield from 5.00% to 3.50% and makes it far less attractive than a company like Royal Dutch Shell Class B shares or ConocoPhillips. Your intrinsic value calculation would have to include some form of tax adjustment because each country lets you keep a differing amount of the profit depending on the type of account in which you held your ownership stake.
Currency Fluctuations Can Make Roth IRA More Volatile
Imagine it is the beginning of January 2008. You have $100,000 sitting in a Roth IRA. You decide you want to buy shares of Nintendo. You convert all of the dollars in your Roth IRA into Japanese Yen, resulting in ¥11,415,000. You are able to buy 200 shares for ¥57,075 per share.
You sit back and do nothing to your Nintendo shares. In 2008, you collected ¥252,000 in dividends, in 2009 you collected ¥288,000 in dividends, in 2010 you collected ¥186,000 in dividends, in 2011 you collected ¥90,000 in dividends, and in 2012, you collected ¥20,000 in dividends.
Thus, your Roth IRA collected ¥836,000 in dividends before taxes over the years you held the stock. When I originally published this article in December 2012, Nintendo traded for ¥9,070 per share, giving your total position a value of ¥1,814,000 plus dividends for a grand total of ¥2,650,000.
That means for patiently waiting almost six years, you lost ¥8,765,000, or 76.78% of your starting investment. You want to wash your hands of the entire deal so you sell the stock and stare at the ¥2,650,000 sitting in your Roth IRA. You call your broker and translate it back into United States dollars and find yourself with $30,789.
At first, that doesn't make sense. You lost 76.78% of your investment, yet here you are with only a 69.21% loss. Where did that other 7.57% originate, offsetting some of your red ink? It had to do with currency translation rates. The United States ran huge deficits and saw its dollar lose value compared to the Yen. In 2012, you could buy more dollars for every Yen than you could back in 2008.
This situation can work the other way, too. In the wrong circumstances, you could have an investment that appreciated in value in the local currency, but when you translated it back to the United States, resulted in a loss. To protect against this, you can pay a fee to hedge your currency exposure or you could keep the money in the local currency and actually go to that country to spend the cash. If you, for example, had a vacation home in Tokyo, the currency rates wouldn't matter as much to you because you could live, eat, and shop using your Yen.
Geopolitical Risks Can Hurt Your Roth IRA Investments
It has been a long time since a world war has broken out and consumed the planet. When that happens, all bets are off because the military of a particular country will most likely nationalize some assets for the sake of security. Imagine you had significant investments in an automobile company in China.
If the United States went to war with China, the Chinese government is very likely going to march into the factory, change the name of the business, and issue new stock to local investors. You now have no ownership. It has happened in the past, and it will certainly happen again in the future.
This was common across Europe during World War I and II when investors saw their cross-country portfolio holdings evaporate overnight as various factions aligned with one another. That doesn't mean international investing in a Roth IRA isn't worth it. It just means you need to pay attention to the world.
Different Countries Use Different Accounting Rules
The accounting rules for Mexico are not the same as they are in the United States. The accounting rules in the United States are not the same as they are in South Korea. If you are making global investments through your Roth IRA, you need to know how to analyze the numbers so you don't wake up to discover that you have made a horrible mistake.
To give you a real-world example: In Mexico, the balance sheet, income statement, and cash flow statement are adjusted for past inflation rates due to the high inflation the economy has suffered. This allows investors to get an idea of what is going on with the enterprise, stripping out the effects of the currency. It is a far superior method than the one used in the United States, where a company can show a 4% "increase" in profits when inflation also ran 4% in a given year.