Diversification across global markets has long been a cornerstone of modern portfolio theory. Many investors naturally allocate to international developed and emerging-market funds to broaden exposure beyond U.S. borders.
Most asset-allocation models include at least 20% international equity, and virtually all target-date funds maintain a meaningful global component.
However, few investors consider where those holdings should reside — in taxable or retirement accounts — even though this decision can impact long-term after-tax returns.
Why International Funds Can Be Tax-Inefficient
Unlike U.S. equities, foreign stocks are subject to dividend withholding taxes imposed by their home countries. These taxes typically range from 0% to 30% of the dividend amount and are non-recoverable inside tax-deferred accounts such as IRAs, 401(k)s, and Roth IRAs.
To make matters worse, international markets tend to have higher dividend yields than U.S. markets.
This occurs because:
- International companies often have lower valuations/growth profiles and higher payout ratios.
- Many use dividends instead of stock buybacks to return capital to shareholders.
For example in the most popular ETF which are also available as funds inside 401(k)s:
- Vanguard S&P 500 ETF (VOO): ~1.15% dividend yield
- Vanguard Total International Stock ETF (VXUS): ~2.75% dividend yield
How Inefficient Is It?
Roughly 10% of VXUS’s dividends are withheld by foreign countries each year.
For large-cap, broadly diversified international funds, 10% is a reasonable rule of thumb for “foreign taxes paid.”
That means:
On a 2.75% yield, an investor forfeits roughly 0.3% annually in foreign withholding taxes when holding VXUS in a retirement account.
For context, VXUS’s expense ratio is only 0.05% — meaning this tax drag is six times larger than the fund’s stated expense.
In taxable accounts, investors can typically claim a foreign tax credit on their U.S. return to offset this cost.
But in retirement accounts, there is no credit available — the withholding is a permanent loss.
Dividends in Taxable Accounts: Qualified vs. Non-Qualified
If you hold international funds in a taxable account, you’ll owe tax on their dividends each year.
Here’s the catch: not all dividends are taxed equally.
- Qualified dividends are taxed at lower long-term capital gains rates (0%, 15%, or 20%).
- Non-qualified dividends are taxed at ordinary income rates, which can be as high as 37%.
U.S. equity ETFs like VOO typically have 99–100% qualified dividends, meaning almost all their income receives the lower rate.
International ETFs are different is that a lower amount of the dividends are qualified. For VXUS, only ~60% of the dividends are qualified.
Why Only ~60% of VXUS Dividends Are Qualified
VXUS, which tracks the total international market, typically reports only ~60% of its dividends as qualified.
The remaining 40% are taxed at higher ordinary income rates.
There are several reasons:
- IRS Treaty Test
Only dividends from countries with a U.S. tax treaty and proper documentation qualify.
VXUS holds many non-treaty markets — such as Brazil, Singapore, and Taiwan — disqualifying a large portion of its income. - Corporate Structure
Some foreign firms operate as holding companies, state-owned entities, or REIT-like structures, whose distributions fail to meet the IRS definition of “qualified dividend income.” - Documentation Gaps
For a dividend to be reported as qualified, the ETF provider must document eligibility.
If not verifiable, the IRS requires it be classified as ordinary.
Bottom Line
In spite of the qualified funds, for broad large cap international funds, it still makes sense to put them in taxable accounts instead of tax deferred account since the foreign tax credit can be claimed.
Most investors recognize that bond and fixed-income funds belong in retirement accounts for tax efficiency, whereas international funds typically work better in taxable accounts.
Strategic asset location — not just allocation — can meaningfully improve long-term after-tax outcomes.
Emerging market funds, small cap international funds and global real estate funds have different tax withholding rates and lower qualified dividends. We will explore later whether it makes sense to put them in taxable accounts too
Disclosure
This material is provided for informational and educational purposes only and should not be construed as individualized tax or investment advice.
Investors should consult with a qualified financial advisor or tax professional before making investment or asset-location decisions.
All data sourced from Vanguard fund reports (2022–2024) and public tax documentation as of October 2025.