Source: Philip Brewer via Flickr.
It's been tough for investors in the U.S. to get much income from their portfolios from traditional sources like fixed-income investments, and so dividend stocks have gotten a lot more popular in recent years. Although there are thousands of U.S. stocks that pay dividends, many international companies also have lucrative dividend payouts that attract millions of investors. Yet before you start looking at those mouth-watering yields on overseas stocks, keep in mind that the IRS and its counterparts abroad could well end up taking an unexpected share of those payouts -- even if you otherwise wouldn't owe any taxes at all.
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Understanding foreign taxes
For U.S. investors who stick with domestic stocks, taxes are pretty straightforward. When you receive dividends from stocks you own in a regular taxable account, you include the dividend income on your tax return and pay the appropriate tax. If you own stocks in an IRA or other tax-favored account, on the other hand, you don't have to include them on your tax return and don't pay current tax on them.
For foreign stocks, though, things get more confusing. Dividend income from a foreign corporation can technically be what's known as foreign-source income, which means that the country in which the company resides gets the first crack at taxing the dividends it pays out. That would potentially leave you having to file a tax return in dozens of different countries.
In order to simplify matters and ensure that they get their cut, most foreign tax agencies never give you a chance to beat the tax rap. Instead, they withhold the taxes due at the source: from the companies themselves or from the financial institutions that hold shares on your behalf.
Unfortunately, it's not always easy to figure out exactly what you'll have to pay. Rates on withholding taxes can be different from every country. Moreover, even if a particular tax rate usually applies, some countries have special tax treaties with the U.S. that give U.S. investors a preferential rate -- or no tax at all -- on their dividend income.
Foreign stock Santander is one example of a high-yielding stock that can have a surprising tax bite. Source: Junius (Own work) [Public domain], via Wikimedia Commons.
Taking a hit to your yield
The net result can be that your after-tax yield can be a lot lower than it would be if withholding tax didn't apply. For instance, take a look at some of the high-yield foreign stocks below. In the table, you can see what their nominal dividend yield is, and then measure the impact that the withholding tax has on your after-tax return, based on the latest figures from consulting firm Deloitte as of Nov. 1, 2014.
Source: Yahoo! Finance, Deloitte. * Tax rate lowered by treaty as of date of publication.
As you can see, yields often will fall by a percentage point or more on high-yield dividend stocks once you consider taxes. You can't afford to ignore withholding tax in your income calculations.
Can you beat the IRS?
There's a silver lining to foreign taxes on dividends. Because the U.S. offers a foreign tax credit, many investors can claim all or at least part of the taxes they pay to foreign governments as a credit against their U.S. tax bill. The IRS form pertaining to the credit can be extremely intimidating to those who aren't experienced with it, but fortunately, those with relatively small amounts of withheld foreign taxes can follow a simpler process to claim the credit.
However, there's a wrinkle that can still hurt U.S. investors. Because IRAs aren't subject to U.S. tax at all, taxes you pay there aren't eligible for the foreign tax credit. Some countries do have special provisions to exempt stocks in tax-favored accounts from facing withholding tax, but many don't. Moreover, even for those that do, your broker might not always follow the right rule, forcing you to face a confrontation in order to get what's due to you.
Despite the added hassles, investing overseas can still be a great way to add diversification and boost your portfolio income. Just make sure that you understand the impact of taxes to avoid any unexpected surprises.
The article How Foreign Dividend Stocks Can Cost You originally appeared on Fool.com.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Total (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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