Recently I got a rather unpleasant surprise with one of the holdings in my retirement account. Last September, I added a few companies based on a series of screens I had done. Popular Inc. (NYSE: BPOP) is a bank based in Puerto Rico. My screens flagged it as significantly undervalued, so I added it to my portfolio on 9/15/2020.

Besides being seemingly undervalued, the company paid a 4.4% dividend at the time I added it. That is generally a requirement for me. I prefer companies that pay dividends.

The share price rapidly rose after I invested. I entered the position at $36.71 a share, and today shares are over $69.00. Over the past six months the company has returned 86%, outperforming high-flying tech stocks like Tesla (NSDQ: TSLA), Amazon (NSDQ: AMZN), and Apple (NSDQ: AAPL).

So, the investment thesis certainly bore fruit. However, when the company paid me a dividend on 1/4/2021, I noticed that 15% was withheld as foreign tax. I thought that was a mistake. To understand why, let’s discuss taxation of dividends from foreign companies.

Understanding the Tax Implications

When a foreign company pays a dividend to U.S. citizens, the taxes due may be withheld by the foreign government. That reduces the dividend and will be reflected on form 1099-DIV, in Box 7 (“Foreign tax paid”). This is different than when U.S. citizens receive dividends from U.S. companies in a non-retirement account. They receive the full dividend, but must settle the taxes on their tax returns.

To avoid double-taxation by the IRS, you can take a foreign tax credit for the taxes paid to the foreign country. But if the foreign company is held in a retirement account, there is no mechanism for claiming that back on your tax return. In this case, you will pay foreign taxes from your retirement account and that will erode your returns over time.

For U.S. companies, taxes aren’t withheld for dividends paid in a retirement account. Consequently, I thought the tax withholding in my case was wrong. My presumption was that Puerto Rico, being a U.S. territory, would apply the same rules as the rest of the U.S. to dividends in retirement accounts.

I wrote to Fidelity and to Popular’s investor relations department, requesting an explanation. Fidelity explained that they couldn’t advise me on this since the withholding was done by Popular. And Popular never responded, despite two follow-up attempts.

Puerto Rico’s Rules

I did some investigating. I learned that I was wrong. Despite being a U.S. territory, Puerto Rico does withhold taxes on dividends in retirement accounts. In this case, there is no mechanism for getting this money back. It’s just gone.

This is a known issue when holding dividend-paying companies in a retirement account. Most foreign countries withhold the taxes with no mechanism for reclaiming them. I just presumed it wouldn’t be an issue for a company based in a U.S. territory. I was wrong.

Fortunately, the significant rise in share price helps offset the small loss of income from this withholding. But losing 15% of an income stream can have a corrosive effect over time. Fortunately, there are ways to avoid this.

First, don’t hold certain foreign dividend-paying companies in your retirement account. In this case, I just didn’t know that Puerto Rico operated under this set of rules.

Second, there are countries that don’t withhold foreign taxes for funds in retirement accounts.

The Exceptions

If you want to hold foreign companies in your retirement account it’s important to know the exceptions to the withholding rules. Most countries withhold taxes on dividends, but some important ones do not.

Countries that don’t withhold taxes on dividends include Hong Kong, India, Singapore, and the United Kingdom. Thus, you can hold a British company in a retirement account and you won’t be taxed on the dividends. It will be functionally as if you held a U.S. corporation in your retirement account.

Canada is also a special case. Although Canada does withhold taxes on dividends paid to U.S. citizens at a 15% rate, U.S. investors are exempt from this withholding if the shares are held in an Individual Retirement Account or 401k.

A country could always change its withholding rules, but right now those countries are your best foreign bets for retirement accounts.

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