The pages of Mindfully Investing make it clear that I’m fascinated with the whole topic of investing. But the details of investment taxes exhaust me, mainly because the U.S. income tax system is so incredibly byzantine and tedious.
But boring things can sometimes be important. Unfortunately, minimizing taxes is one of the few aspects of investing that we have some control over. And seemingly trivial annual taxes (and other costs) can make a massive difference in the compounding of investments over time. Each wave that crashes against a cliff may only move a few pebbles, but enough waves over time can cause a mighty edifice to crash into the sea.
Some Simple Tax Rules for Investing
Given my distaste for learning about taxes, I’m no tax expert. And I’m certainly not providing any tax “advice” here at Mindfully Investing. But personally, I follow a few simple rules that help minimize investment taxes including:
- Max out tax-advantaged retirement contributions first, and then invest any remaining savings in taxable accounts.
- Among tax-advantaged accounts, contribute first to any available employer retirement plan (like a 401K) up to the match level.
- Evaluate whether you will pay more in total taxes by contributing to tax-deferred accounts like Individual Retirement Accounts (IRAs) or after-tax “Roth” accounts.
- Consider how early withdrawal penalties and Required Minimum Distributions (RMDs) might impact the availability and taxation of your money as you age.
And here are a few more rules for investments in taxable accounts:
- Exchange-Traded Funds (ETFs) are generally more tax-efficient than mutual funds.
- Stock funds are generally more tax-efficient than bond funds.
- Stock index funds are generally more tax-efficient than actively managed funds.
- Minimize capital gains by limiting unnecessary sell events, for example when rebalancing.
- Stock funds that pay higher dividends usually produce slightly worse income tax outcomes.
- Avoid wash sales and short-term stock trading in general, which are taxed at higher rates.
As a non-expert with no appetite for tax details, I freely admit that my simple tax rules may be deficient in many respects.
International Stock Dividends
However, this year, as my tax statements were rolling in, I noticed one new detail. Specifically, my U.S. stock funds produced mostly “qualified dividends”, while my Developed Market (excluding the U.S.) and Emerging-Market stock funds produced a lot of “non-qualified” dividends.
Why do I care? Qualified dividends are taxed at a lower rate than non-qualified dividends. So, by investing in international stock funds in a taxable account, a larger portion of my annual dividends are taxed. (Note that this whole dividend tax issue does not apply to tax-advantaged accounts where dividends aren’t taxed as they accrue.)
I’ve argued back and forth in past posts about the merits of investing in international stocks versus U.S. stocks only. Over the years, I’ve concluded that diversifying a stock portfolio with international stocks is a good idea. But you can certainly argue, as Warren Buffett and John Bogle have, that holding only U.S. stocks provides sufficient diversification.
So, I started to wonder whether the cost of the higher dividend taxes might outweigh the diversification benefits of holding international stock funds. And that’s the question I want to address in the remainder of today’s post.
Dividend Tax Brackets
First, non-qualified dividends are taxed as ordinary income. So, the amount of additional taxes you pay on non-qualified dividends depends on your income bracket.
This table shows the married joint-filing ordinary income brackets as compared to dividend tax brackets. I used approximate income thresholds here to help match up the income and dividend brackets, which are slightly different¹.
| Joint Filing Approximate¹ Tax Brackets | Non-Qualified Dividend Tax Rate (or Ordinary Income Rate) | Qualified Dividend Tax Rate | Difference in Tax Rates |
| $20K – $80K | 12% | 0% | 12% |
| $80K – $171K | 22% | 15% | 7% |
| $171K – $327K | 24% | 15% | 9% |
| $327K – $415K | 32% | 15% | 17% |
The brackets go higher than $415,000, but these brackets are likely to be relevant to a majority of investors. And I suspect most readers of this blog are in brackets less than $327,000, where you pay around 10% more in taxes on any non-qualified dividends (as shown by the range of 7% to 12% in the right-most column).
Percentage of Non-Qualified Dividends
Second, we need to consider how much of the dividends from international stock funds tend to be non-qualified. I’m partial to Vanguard ETFs because of their generally low costs. So, here’s a sampling of the non-qualified dividends from Vanguard ETFs that include at least some non-U.S. stocks.
| Vanguard Fund | Percent Non-Qualified Dividend |
| Vanguard ESG International Stock ETF | 34% |
| Vanguard FTSE All-World ex-US Small-Cap ETF | 44% |
| Vanguard FTSE All-World ex-US ETF | 26% |
| Vanguard FTSE Developed Markets ETF | 20% |
| Vanguard FTSE Emerging Markets ETF | 54% |
| Vanguard FTSE Europe ETF | 14% |
| Vanguard FTSE Pacific ETF | 20% |
| Vanguard Global ex-U.S. |
53% |
| Vanguard International Dividend Appreciation ETF | 27% |
| Vanguard International High Dividend Yield ETF | 26% |
| Vanguard Total International Stock ETF | 28% |
| Vanguard Total World Stock ETF | 12% |
The two funds shown in red are the two international stock funds that I use in my own portfolio. And it turns out that my Emerging-Market fund (ticker VWO) has the highest percentage of non-qualified dividends among these funds.
The Impact of Non-Qualified Dividend Taxes
At this point, it sounds terrible that holding an Emerging-Market ETF (like VWO) results in more than half (54%) of the dividends being subject to a roughly 10% higher tax rate. But the more relevant question is how big of a bite do those additional taxes take out of the compounded long-term returns of international funds?
Because Emerging-Market ETFs have the highest percentage of non-qualified dividends, I used the percentage of non-qualified dividends from VWO to calculate two scenarios as the “worst-case” examples of the additional long-term taxes potentially associated with international stock funds. In both scenarios, I used the 26-year history of Emerging-Market returns from Portfolio Visualizer.
Retirement Scenario – For retirees, I assumed the investor would withdraw a constant (not inflation-adjusted) 4% annually from an initial $500,000 investment in VWO.² The 26-year history of Emerging-Market returns generates a relatively short retirement, and many experts suggest a withdrawal rate that’s adjusted to keep pace with inflation. However, I think both of my assumptions are adequate to estimate the general magnitude of additional taxes involved in a retirement scenario.
The blue line in the graph below shows the growth of the investment (minus withdrawals) in a hypothetical Emerging-Market fund that matched the Portfolio Visualizer annual returns but with 100% qualified dividends. The orange line shows the growth of the same hypothetical fund with a 10% higher tax rate on 54% of the dividends.
There’s clearly a difference between the 26-year outcomes of the two scenarios, but the final difference is only $35,000 of additional taxes with a final portfolio value of about $900,000.
This second graph shows the accumulation of the additional taxes both in dollar terms (blue bars) and as a percentage of the running total account value (orange line).
The additional taxes due to non-qualified dividends represent just 4% of the total fund value after 26 years. A 4% loss may sound like a lot to some readers, but that’s a loss over 26 years, not an annualized loss. In annualized terms (compound annual growth rate or CAGR) the additional taxes caused a tiny difference:
- CAGR assuming 100% qualified dividends = 2.50%
- CAGR for 54% non-qualified dividends = 2.36%.³
The Young Investor Scenario – The second scenario is for a young saver, who’s not withdrawing money, but instead, is adding money to their account each year as part of a retirement savings and investing plan. I used a starting median salary of $50,000, a savings rate of 10%, and annual salary/savings increases of 3% as described more in my Game of Life post. Here are the same two graphs for the young investor scenario.
Here the difference in final account values (with and without the additional non-qualified dividend tax) is even smaller, just $17,000 or 2.2% over 26 years.
The Price of Diversification
The above calculations compare two funds with identical sequences of returns. But the whole idea behind diversification is that one type of fund might perform better during market turmoils than other funds in your portfolio. Consider what happened from 2000 to 2009, which has been called the “lost decade” for U.S. stock investors, as shown in this table.
| Stock Classification | Annualized % Return |
| U.S. Stocks (S&P 500) | -1.03% |
| Developed-Market Stocks (ex.-U.S.) | 1.24% |
| Emerging Market Stocks | 9.82% |
During the lost decade, Emerging-Market stocks trounced U.S. stocks to the tune of 10.85% annualized! My calculations above suggest that the erosion from non-qualified dividend taxes would have only reduced that huge win for Emerging-Markets stocks to something like 10.70%. That seems like a small price to pay for significant diversification. Of course, this sort of huge diversification benefit won’t happen all the time. But even if international stocks only outperform by 1% annualized, it would more than justify the relatively small additional dividend taxes.
Foreign Tax Credit
Outside of the issue of non-qualified dividends, international stock funds also involve the so-called “foreign income tax credit” on dividend taxes paid to other countries. The taxes paid to other countries are figured and taken out by your broker before you ever receive your dividends. But under U.S. tax law you generally get a credit on your U.S. tax return for foreign taxes paid up to $600 per year when filing jointly. In other words, those foreign taxes decrease your U.S. taxes by the same amount.
If you paid more than $600 in foreign taxes in a given year, you can still get some amount of credit above $600. But you have to fill out a form that comes with 24 pages of instructions! This is a good example of why I used the words “byzantine” and “tedious” when I described the U.S. tax system at the top of this post.
Some people argue that the foreign tax credit makes international stock funds more tax efficient. But I agree with the counter-argument that you paid those taxes anyway, even though they didn’t go to Uncle Sam. It’s just that you’re not getting hit with the same taxes twice. The foreign tax credit is kind of like using charitable contributions to reduce your tax bill. Undeniably, contributing enough money to charities (or foreign taxes) can reduce your U.S. tax bill, but you can’t buy something else with those departed contributions (or foreign taxes).
Conclusion
Another way to address the question of international stock fund tax-efficiency is to consider the tax consequences of placing all international stock funds in tax-advantaged accounts versus taxable accounts. In tax-advantaged accounts, you get to defer or eliminate all taxes on dividends, but you don’t get the foreign tax credit. In taxable accounts, the situation is reversed. If you’re hungry for even more tax minutiae, Physician on Fire wrote an extremely detailed and helpful post regarding the best account placement for international stock funds.
Based on my analysis (and that of Physician on Fire), my conclusion is that the tax erosion from international stock investing doesn’t significantly impair the potential benefits of international diversification. This issue falls within the noise of mindful investing.
And if you’ve accumulated any international stock funds at all, it would be silly to suddenly start selling them just to move between taxable and tax-advantaged accounts or vice versa. That’s because all that selling and shuffling of stock funds could easily trigger either capital gains taxes in taxable accounts or income taxes and early withdrawal penalties in tax-advantaged accounts. Buying and selling too much is almost always tax-inefficient.
1 – Of course the brackets are slightly different because that helps make the U.S. tax system even more bizarrely intricate and confusing. And because I’m showing approximate brackets in this table, you definitely should not use this table, or anything in this post, to prepare your taxes.
2 – I used the rule-of-thumb that retirees should save 25 times their assumed annual living expenses (budget) for retirement. An annual budget of $60,000 (slightly less than the median household income of $65,000) multiplied by 25 gives a retirement nest egg of $1.5 million. I then assumed that an aggressive investor might place one-third of their nest egg in Emerging-Market funds, which gives the $500,000 starting value that I used in these calculations.
3 – Given that the CAGR for emerging markets over this same period was about 6.5%, these CAGRs may seem really low to you. But remember that these values include a 4% annual withdrawal, which severely depresses the long-term returns of the account.
