The Pitfalls of Investing In Foreign Dividend Stock in a Roth IRA

What To Consider If You Buy Foreign Investments

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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 invest in tax-deferred retirement plans like Roth IRAs because of their unique tax and regulatory restrictions. To successfully navigate the international waters, there some pitfalls to be aware of before you invest in foreign dividend stock through a Roth IRA.

Taxes Can Diminish Roth IRA Dividend Yields

Foreign governments generally require U.S. brokerage firms to withhold taxes on dividends that U.S. citizens earn from stock in companies based in their countries. Some countries withhold 0% in dividend taxes to foreign investors (e.g., the United Kingdom) and some withhold significantly more (30% in France, for example). As long as the dividend tax withholding rate is above zero, the taxes withheld by the foreign government will reduce your dividend payout.

But your tax liability doesn't end there, as the IRS also requires you to pay taxes on dividend income. To avoid double taxation, tax treaties allow U.S. investors to recoup some or all of the taxes they pay on assets held in taxable accounts like regular brokerage accounts (either as an itemized deduction or a tax credit), but not in non-taxable accounts like IRAs. This is because IRAs are tax-deferred accounts that don't require you to pay any taxes on income from those accounts until the time of withdrawal (money in a Roth IRA is usually tax-free even upon withdrawal).

While this doesn't mean that you shouldn't hold foreign dividend stock in a Roth IRA, it's important to consider the dividend tax withholding rates and dividend yields that apply to your chosen foreign investments when deciding whether the strategy is right for you.

Share Classes May Be Taxed Differently

Many large international companies maintain dual listings in multiple countries, and these different share classes may tax dividends at different rates. Global investors should select the share class that is most beneficial for their particular tax situation.

A perfect example is Royal Dutch Shell, a British–Dutch oil and natural gas giant. The company has two classes of stock: Class A and Class B shares. Dividends on Class A shares are subject to Dutch withholding taxes (usually at a rate of 15% for American citizens). American citizens will often do better by purchasing Class B shares because no U.K. or Dutch dividend taxes will be withheld, resulting in higher dividend yields.

Based on the current dividend yield of 8.4% of Royal Dutch Class A shares as of April 2020, $100,000 invested in Royal Dutch Shell Class A shares in a Roth IRA would receive around $7,140 in cash dividends per year after 15% is taken out in taxes. The same $100,000 Roth IRA invested in Royal Dutch Shell Class B shares would receive $10,230 in cash dividends per year at a dividend yield of 10.23%. 

That is an extra 43% cash return for owning what effectively amounts to the exact same assets. Over a few decades, as dividends were reinvested, the net difference in wealth between the Class A and Class B shareholders who held their foreign dividend 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 bought shares of Total, SA, the French oil giant, the same $100,000 would generate $6,077 in dividend income in April 2020 prices, but the French government would take $2,031 and send your Roth IRA the remaining $4,739. The higher dividend tax rate of 30% makes the shares far less attractive than Royal Dutch Shell Class B shares.

Your calculation of the intrinsic value of a foreign stock should include some form of tax adjustment because each country lets you keep a different amount of the profit depending on the type of account (taxable or non-taxable) and share class in which you hold your ownership stake.

Currency Fluctuations Increase Foreign Stock Volatility

Let's say that you have money sitting in a Roth IRA and convert all of it into a foreign currency in order to invest it in a foreign dividend stock. Fluctuations in currency exchange rates are such that if even if you lose money in the local currency, you could wind up with a smaller loss in U.S. dollars. For example, between mid-2009 and 2012, the U.S. ran huge deficits and saw its dollar lose value compared to the Yen, which means that you could buy more dollars for every Yen in 2012 than you could in 2009. This could have helped you recoup some of your losses from investing in a Japanese company that fared poorly over that period, such as Nintendo.

However, the greater danger is when the situation works the other way. In the wrong circumstances, you could have a foreign investment in a Roth IRA that appreciates in value in the local currency but results in a loss when you translate it into U.S. dollars because of a devaluation of the other country's currency.

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 travel to that country to spend the cash there. For example, if you had a vacation home in Tokyo, the currency rates wouldn't matter as much to you because you could live, eat, and shop using Yen.

Geopolitical Risks Can Hurt Roth IRA Investments

A long time has passed since a world war broke out and consumed the global economy. If and when that were to happen, all bets would be off because the government of a particular country may well nationalize some foreign-owned assets for the sake of security.

Imagine that your Roth IRA had a significant amount invested in an automobile company in China. If the United States went to war with China, the Chinese government could confiscate the stock of shareholders affiliated with the enemy and issue new stock to local investors. You now have no ownership and may find it difficult to seek compensation for your old holdings.

This has happened in the past, and it can happen again in the future despite the slim chances of geopolitical strife on that scale. The practice of nationalizing foreign assets 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. This means that if you proceed with international investing in a Roth IRA, you'll need to pay attention to world affairs and accept that your portfolio will be exposed to additional global risk.

Different Accounting Rules May Apply Abroad

Viewing and interpreting financial statements is an essential component of investing because it allows investors to get an idea of the financial health of an enterprise. However, this task poses a challenge for Americans who invest in international dividend stocks through their Roth IRA because the accounting rules for Mexico and other countries aren't the same as they are in the U.S.

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 the 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.

If you are making global investments through your Roth IRA, you need to know how to analyze the numbers or consult with a financial advisor who does so that you're not forced to guess at the viability of a particular investment and can avoid making costly mistakes.

Article Sources

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