In this summary, we cover:
- What investing tax-efficiently means
- How to gauge whether an investment is tax efficient or not
- The various types of tax efficient investments for foreigners
- An ROI of an investment has to be keenly analyzed to gauge whether it is tax efficient or not.
- Taking advantage of tax credits as a foreign investor is better than going for a tax deduction.
- It makes sense to defer taxes by going for tax-deferred investments such as retirement accounts.
- If you’re planning to invest in the US retirement plans, conduct due diligence about your country’s plan. Similar plans don’t qualify for US tax deferment.
- Understand that your tax ‘residential status’ will determine the tax treatment you will be subjected to under the US tax laws.
Tax efficiency is essential towards maximizing returns of any investment. From a financial dictionary, tax efficiency is defined as “a measure of how the return on an investment is left over after taxes are paid.” Unfortunately, many foreign investors find it difficult to understand how to minimize their taxes and maximize returns due to the complex US tax laws. The complexities associated with both taxation and investing leaves many investors spending untold hours researching mutual funds, bonds, and stocks with attractive returns.
Many investors today believe in diversification into various industries—this means including portfolios from different parts of the world, as well. As a matter of fact, “wealth experts recommend channeling at least a third or more of one’s holdings into foreign investments to breed a safer and efficient portfolio.”
But before getting to know how to invest efficiently, let’s first of all, get the basics right, shall we?
Are you a resident or Non-resident?
Foreign persons who invest in the US are taxed depending on whether they are residents or not. A person, under the tax laws, is prescribed to mean an individual, a corporation, a partnership, or a trust. Once the residency status is determined, different rules apply to individuals, corporations, partnerships, and trusts.
In this article, the word “person(s)” will be used under the same context as in the US tax laws.
Here’s a little breakdown of how the respective persons are taxed.
An individual who passes as a US resident is taxed on worldwide income in the same way as a US citizen. On the other hand, a non-resident is taxed on US-sourced income or income associated with the US sources only. Non-residents with incomes not sourced from US investments get exempted from federal income taxation.
The residency status in the current year of taxation of an individual is said to be as a result of the following.
- An individual holding a green card lawfully and permanently residing in the US at any given time during the taxable year;
- Makes a first election; or
- Meets the substantial presence test.
Generally, foreign corporations are subjected to US federal income tax for gains resulting from a US business, trade, or attributable to a US-source.
Partnerships and Trusts
Foreign trusts and partnerships are not subjected to income tax; rather if the beneficial owners of the partnership or trust are found to have derived income for the US, they incur income tax. An income gained by a trust may be taxed on the trust itself or the beneficiaries.
Now that the basics are clear, let’s consider some of the tools you can use to tax-efficiently invest in the US as an individual or a foreign company.
Return on Investment
When looking at an investment, whatever it may be, you always have a keen eye on the Return on Investment (ROI)—and then, subtract taxes to be paid. If the remaining figure is enticing enough, you consider the investment viable.
Consider this example:
A person can hold a bond worth $10,000 that promises a return of $1,000 on maturity, which is an ROI of 10%. If the applicable tax rate thereof is 30%, you’ll end up with $700; leaving you with an ROI of 7%.
On the other hand, consider the same person holding 1000 shares of X Corporation that will sell at a long-term gain of $10,000; also with a 10% ROI. If the long-term capital gains tax of this investment is 15%, that is, $1,500, then this means that you’ll end up with an ROI of 8.5% ($10,000-1,500=$8,500 gain).
Now, looking at these two portfolios, X stock is more efficient as compared to the bond investment—even though they both have an initial ROI of 10%. If the investor would choose to invest in X corporation over the bond, this would then be an example of a tax efficient way of investing.
Make sense? Let’s move on then.
Foreign Tax Credit
Other than evaluating the ROI of a portfolio after taxation, you can also invest tax-efficiently by taking advantage of the foreign tax credit.
Every state has its own tax laws governing foreign investment—and this can vary dramatically from one state to another. Take, for instance, in Italy—they take 20% from proceeds of stocks sold by non-residents. Germany, on the other hand, scoops slightly more at about 21%.
While it doesn’t hurt to research about the tax rates prior to making an investment in especially stocks, the IRS offers a means to avoid double taxation anyway. For all qualified taxes paid, you can get tax credits or deductions on your tax returns.
Tax credit immensely reduces the actual tax due on your income. A tax credit of $1,000 translates to $1,000 worth of tax savings—great, right? But should you opt for a deduction, and you happen to be in the 25% tax bracket, you can only get a tax saving of $250 ($1,000X0.25). So, you’re better off going for a tax credit as opposed to a deduction; which is tax efficient.
In most parts of the world, you’ll realize that these two types of investments are tax deferred and tax exempt.
- Tax-deferred investments—these are investments that are not taxed until a later date. They include investments such as IRAs, 401(k) s, and other US retirement accounts. These investments allow you to defer being taxed when you are at a higher income bracket (when working) to a later stage when at a lower tax bracket (when retired). The US only recognizes plans that are US based. However, be sure to research on the plans in your resident country as foreign plans that are fundamentally similar (such as Australian superannuation plan) don’t qualify for US tax deferment.
- Tax-exempt Investments—these are investments that don’t attract the federal income tax. One of the most typical ones to invest in is the US municipal bond.
If you are a foreigner residing in the US, you have quite a number of ways to invest in a tax efficient way; so you won’t break the bank. Be sure to conduct due diligence from qualified US-based professionals for a better understanding of how to invest tax-efficiently in the US as a foreign individual or company.