Want to Invest in Foreign Stocks? Try Looking Outside Your 401(k)

If you’re thinking of moving money into an international stock fund right about now, you’re not alone. As we reported last week, Americans in June have dramatically stepped up their investments into international funds, based on the spectacular gains of many Asian and Latin American portfolios. Some funds are up as much as 60% to 70% year to date.

Assuming you want to do the same, how should you go about it? For instance, should you invest in these funds through your company-sponsored 401(k) retirement plan if there is an international option?

“You want to be careful investing any money in a foreign fund inside a qualified plan” such as a 401(k), warns Barbara Raasch, partner in Ernst & Young’s personal financial counseling group in New York. “You really want to try hard, if at all possible, to invest in foreign funds in an outside account.”

Why?

One reason has to do with taxes, which may sound strange because investments within a 401(k) are tax-deferred.

When you receive dividend or interest income from your international funds, chances are, some money will have been withheld to cover foreign taxes.

Now, depending on the circumstances, you may be eligible to reclaim the money withheld, either through a tax credit or an itemized deduction on your federal returns.

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Say you’re a longtime shareholder of the XYZ Diversified International Fund, and you earn $1,000 in dividend and interest income this year. If $300 of that is withheld to pay foreign taxes, you can claim a $300 foreign tax credit on your 1040.

(Generally speaking, you’ll be better off claiming the credit and not the itemized deduction. The credit will lower your foreign taxes $1 for $1, whereas the deduction will reduce them by only 28 cents on the dollar for someone in the 28% tax bracket. However, if the foreign tax credit is more than $300, you’ll have to fill out Form 1116, which is “one of the more complicated tax forms ever created,” says Rande Spiegelman, manager of KPMG’s personal financial planning services in San Francisco.)

If, however, your international funds are in your 401(k)--or an IRA--you won’t be eligible to reclaim the money.

To be sure, in many cases, the foreign tax withheld “is pretty small,” says Ron Roge, a financial planner in Bohemia, N.Y. (Indeed, if you invest only a few thousand dollars in international funds, the foreign tax could be so minimal that you might not care.)

And Mike Scarborough, president of Scarborough Group, an Annapolis, Md.-based 401(k) investment advisory firm, raises a good point. “A lot of people don’t have enough money, after contributing to their 401(k), to buy a foreign fund on the outside,” he says.

And if that’s the case, investing a small portion of your 401(k)--say 10% to 20% or so--in international funds may make sense.

“Based on all the studies I’ve seen, if you have equity exposure, you can cut down on the volatility of that exposure by putting some of it into foreign stocks,” Scarborough says.

That said, “to the extent that you have both taxable and nontaxable accounts and you can reasonably and conveniently keep your foreign funds outside the tax-deferred setting, that would make good sense,” says Kaye Thomas, a Chicago tax attorney and author of the online Fairmark Press Tax Guide for Investors.

Remember, missing out on even a $300 annual tax credit each year turns into a loss of $50,000 over 30 years, assuming you could have earned 10% on the money.

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Aside from taxes, there’s a practical reason you might want to find an international fund in an outside account.

While it’s true that most plans offer an international fund as an investment option--seven out of 10 plans now offer either a “foreign” fund (which invests only overseas) or a “global” fund (which can invest in a combination of overseas and U.S. stocks), up from two in 10 back in 1993--most plans offer just one international fund.

That fund may or may not be a good one. Historically, the disparity in performance among international funds has been far greater than the disparity among U.S. stock funds, according to Bill Dougherty, an analyst with Boston-based mutual fund consultant Kanon Bloch Carre.

And it may or may not be suitable to your investment needs or tastes.

For instance, if you’re chasing big returns (which isn’t necessarily advisable), you’re probably looking for funds that invest in Latin America or Asia.

But emerging markets funds aren’t found in most 401(k) plans. Instead, the typical international fund in a 401(k) invests heavily in Europe--the one region this year that’s been losing ground, rather than gaining it.

Does that mean you shouldn’t invest in a European fund?

No. It can still be a good long-term investment. The point is, if you’re dead-set on investing in an international fund through your 401(k), know that your choices are limited.

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Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.