When you pay foreign taxes on an investment, you have a choice of two ways to deal with it on your US tax return.
- You can take a deduction for the taxes. The value of this is approximately your marginal tax rate x the taxes.
- You can take a credit. In this case, your US tax is reduced by the full amount of the foreign tax.
If the investment is held in a tax-deferred account like an IRA, you cannot generally use either of these methods. However, the foreign taxes are paid by the IRA, so the total value is reduced. This will reduce the taxes you’ll pay when you eventually start withdrawing from the IRA.
However, if it’s a Roth IRA, you don’t pay taxes on the withdrawal at all. So this is reducing nothing.
And even if it’s a regular IRA, your tax bracket at retirement is likely to be lower than when you’re working. So the net benefit will be lower than if you take an immediate deduction. You also can’t reinvest what you saved early, and get the benefit of years of compounding the returns.
So just taking the foreign tax implications into account, it seems like it’s best to invest in a non-qualified portfolio. Taking the credit is preferable (but I think the paperwork is a little more complicated), taking the deduction is next best.
