Author Topic: International fund in taxable for tax credit?  (Read 388 times)

kpd905

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International fund in taxable for tax credit?
« on: July 07, 2018, 02:34:51 AM »
I am finally getting around to starting a taxable account this year.  I know the Boglehead's tax efficiency article says to put international funds in taxable accounts to get the foreign income tax credit, but I have also heard that international funds tend to pay out a higher percentage of non-qualified dividends, which will be taxed at ordinary income tax rates.

Is it worth trying to get that tax credit? Or should I just put a Total US stock fund in there to avoid those non-qualified dividends?  Also, is it a pain at all to file for that tax credit?

terran

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Re: International fund in taxable for tax credit?
« Reply #1 on: July 07, 2018, 06:22:26 AM »
This is probably the Bogleheads page you're looking at: https://www.bogleheads.org/wiki/Tax-efficient_fund_placement. So looking at the "Hypothetical tax costs" table there:

> A total market index has a 2% dividend, all of which is qualified and no foreign tax credit for a total tax cost of Total Balance x 2% x LTCG rates
> A total international market index has a 1.85% dividend, 75% of which is qualified and a 0.15% foreign tax credit for a total tax cost of Total Balance x (1.85% x 75% x LTCG rates + 1.85% x 25% x regular rates - 0.15%), which simplifies to Total Balance x (1.3875% x LTCG rates + 0.4625% x regular rates - 0.15%)

Lets's say you have a $100k balance.

In the 12% bracket:
Domestic: $100k x 2% x 0% = $100k x 0% = $0 tax
International: $100k x  (1.3875% x 0% + 0.4625%  x 12% - 0.15%) = $100k x -0.0945% = -$94.50 tax ($94.50 refund)

In the 24% bracket:
Domestic: $100k x 2% x 15% = $100k x 0.3% = $300 tax
International: $100k x  (1.3875% x 15% + 0.4625%  x 24% - 0.15%) = $100k x 0.169125% = $169.13 tax

In the 37% bracket (I think there might be an extra 3.8% medicare surcharge at this income level too that I'm ignoring, but I think that would apply to both foreign and domestic the same and qualified and non-qualified dividends the same giving foreign a slightly larger advantage due to the lower yield):
Domestic: $100k x 2% x 20% = $100k x 0.3% = $400 tax
International: $100k x  (1.3875% x 20% + 0.4625%  x 37% - 0.15%) = $100k x 0.298625% = $298.63 tax

So, as you can see the foreign tax credit saves you varying amounts depending on your tax bracket. Most states tax all dividends the same, so the lower dividend yield of foreign stocks should help there a bit too.

The credit is very easy to take as the 1099 from your brokerage will tell you how much it is and then you enter it on line 48 of form 1040 (the line seems likely to change this year). If the credit goes over $300 single / $600 married or you pay other foreign taxes (like from working in another country) things get significantly more complicated (see https://forum.mrmoneymustache.com/taxes/form-1116-what-a-nightmare-any-tips-on-how-to-handle-this/) and the amount of the credit you can take goes down, so you end up carrying it forward to future years. For this reason you might consider keeping your taxable international investments below this threshold, which would be about 300/0.15% = $200k and 600/0.15% = $400k respectively. Since the 0.15% foreign tax credit as just an estimate keep an eye on things as you approach the threshold to decide what you want to do (probably worth leaving some buffer).

Edit: You might find the spreadsheet linked from https://www.bogleheads.org/forum/viewtopic.php?t=242137 useful. You'll have to save a copy to edit the tax rates for your personal situation. The spreadsheet seems to contradict what I've written above for higher tax brackets when there's a state tax. I think maybe the reason for that is that he seems to be using a higher dividend yield than the bogleheads table (more like 3% international and still 2% domestic), so you'd end up paying more state tax for international. Not sure why the difference in yield from the bogleheads table, but since he updates it every year I would tend to trust the spreadsheet in this instance. If you're in the 0% LTCG bracket then international seems to be the clear winner even with a state tax. 
« Last Edit: July 07, 2018, 06:42:39 AM by terran »

kpd905

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Re: International fund in taxable for tax credit?
« Reply #2 on: July 07, 2018, 02:37:52 PM »
Damn, I was not expecting a reply that thorough.  Thanks a lot!

I think I'll go with the international because I am in the 12% bracket, and don't expect to hit anywhere close to the $400k in that fund.

terran

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Re: International fund in taxable for tax credit?
« Reply #3 on: July 07, 2018, 03:47:18 PM »
Yeah, that's what we do, also in the 12% bracket. I was surprise to learn from that spreadsheet I linked to that the common wisdom as presented in the Bogleheads wiki might actually be accurate once you pay tax on qualified dividend if you live in a state that taxes dividends. I guess I'll worry about that if we ever go above the 12% bracket.