For European investors seeking to optimize their investment returns, understanding the intricacies of withholding taxes on dividends is essential. In this comprehensive guide, we’ll delve into the complexities of withholding taxes, explore strategies to minimize their impact, and focus on the benefits of Irish domiciled ETFs as a tax-efficient solution. Whether you’re aiming for financial independence or seeking to grow your wealth, this guide will provide you with insights to make informed investment decisions.
I have found that US-domiciled ETFs generally have lower management costs (TERs), but that they cannot be purchased by European investors unless you become an accredited investor. Another consideration is that US companies do not pay the withholding tax on dividends paid to US ETFs. But what are withholding taxes (WHT)?
1. Withholding Taxes on Dividends 101
Gain a clear understanding of withholding taxes by breaking down Level 1 and Level 2 Withholding Tax (L1WHT and L2WHT) scenarios.
I take in consideration the US because the majority of stocks in the market are from there. But you can apply the same concept to the other countries in the world.
- L1WHT: it applies when a company distributes a dividend to another entity, with a different tax domicile. Common case example: Apple distributes a dividend to an Ireland ETF.
- L2WHT: it applies when an ETF distributes a dividend to another us, with a different tax domicile. Another common case example: XDWL (domiciled in Ireland) distributes a dividend to us.
2. Strategies to Optimize Withholding Taxes
Explore a range of strategic approaches to minimize the impact of withholding taxes on dividends for European investors:
- Example 1: Tax Treaty Benefits: European investors can take advantage of tax treaties that exist between their home country and other jurisdictions. For instance, the US-Ireland tax treaty reduces the withholding tax rate on dividends paid from US companies to Irish domiciled ETFs. By holding Irish domiciled ETFs, you can leverage this treaty to benefit from the reduced withholding tax rate, effectively optimizing your returns.
- Example 2: Blend of Low and High Tax Jurisdictions: Consider a scenario where you hold a combination of securities from low withholding tax jurisdictions and higher withholding tax jurisdictions. The dividends from securities in low tax jurisdictions can offset the potential tax burden from securities in higher tax jurisdictions. This balance can help you achieve a more favorable overall withholding tax rate, enhancing your dividend income.
- Example 3: Combining Accumulating and Distributing ETFs: Investors can diversify their portfolio by combining accumulating and distributing ETFs. Accumulating ETFs reinvest dividends automatically, while distributing ETFs pay out dividends to investors. By allocating funds across both types, you can manage your tax liability effectively. For instance, you might hold accumulating ETFs in a tax-advantaged account and distributing ETFs in a standard account to optimize your tax efficiency.
US based Accumulating ETF doesn’t exist. I don’t know why but they cannot be found neither on etf.com nor on etfdb.com. The funny thing is that Americans who want an accumulation ETF have to buy it in Europe.
Let’s see the Irish Domiciled ETF to reduce Withholding Taxes on Dividends for European Investors
3. Irish Domiciled ETFs: The Tax-Efficient Solution
Irish domiciled ETFs offer a compelling tax-efficient solution for European investors seeking to maximize their returns. Let’s explore this concept with examples and numbers to showcase the tangible benefits of investing in these funds:
- Suppose you are a European investor holding a US-based ETF that tracks the S&P 500 index. If this ETF is domiciled in the United States, you might be subject to the standard US L2WHT rate of 30% on dividends. US ETF has 0 L1WHT from US companies. However, if you opt for an Irish domiciled ETF tracking the same index, you can take advantage of the US-Ireland tax treaty, which reduces the L1WHT rate to 15%. Often the L2WHT for European investors with Ireland ETF is 0. Suppose also that all the dividends received from the companies is turned from the ETF to the investors.
- US Companies Dividend: $1,000
- L1WHT: $0
- US Domiciled ETF Dividend: $1,000
- L2WHT (30%): $300
- Net Dividend Received: $700
Now, let’s consider the same scenario with an Irish domiciled ETF:
- US Companies Dividend: $1,000
- L1WHT (15%): $150
- Irish Domiciled ETF Dividend: $850
- L2WHT (0%): $0
- Net Dividend Received: $850
By choosing an Irish domiciled ETF, you save $150 in withholding taxes on the same dividend amount. This reduction directly contributes to a higher net dividend received and enhanced overall returns. In the example it is not considered the dividend tax of the own country.
4. Irish Domiciled ETFs: The Estate Tax Exemption
Another significant advantage of Irish domiciled ETFs is the exemption from the US estate tax. Suppose you have a substantial investment in US-based securities. In the unfortunate event of your passing, your beneficiaries could potentially be subjected to the US estate tax on your US assets. However, by holding Irish domiciled ETFs, your investment is exempt from this tax, providing protection and preserving your wealth for future generations.
- US-Based Assets: $1,000,000
- Potential US Estate Tax (40%): $400,000
Irish ETF example:
- Irish Domiciled ETF Assets: $1,000,000
- Potential US Estate Tax (0%) (Exempt from US estate tax)
In this scenario, by allocating a portion of your investments to Irish domiciled ETFs, you can shield that portion from the US estate tax, resulting in substantial savings for your beneficiaries.
5. Irish Domiciled ETFs: The Accumulating ETFs for Compounding
Irish domiciled ETFs also offer accumulating options that automatically reinvest dividends, allowing for seamless compounding. This eliminates the need for manual reinvestment, reducing transaction costs and enhancing the growth potential of your investments.
Example: Assuming an investor holds an accumulating Irish domiciled ETF with an average annual dividend yield of 2%. If they invest €10,000 over 10 years:
- Initial Investment: €10,000
- Annual Compounded Growth (2%): €200
- Total Value After 10 Years: Approximately €12,190
Compared to distributing ETFs that pay out dividends, the accumulating ETF enables more efficient compounding, leading to higher long-term growth.
6. Evaluating Irish Domiciled ETFs: The tradeoffs
When it comes to Irish Domiciled ETFs, it’s important to acknowledge a couple of tradeoffs that exist alongside their tax advantages. These considerations offer a balanced perspective for investors to make well-informed decisions.
1. Bid-Ask Spread and Trading Volumes: Irish Domiciled ETFs may exhibit lower trading volumes compared to their US counterparts, which can lead to a slightly higher bid-ask spread. Think of this as a subtle cost that investors need to be aware of.
2. Commission Differences: Another aspect to consider is that the commissions associated with trading on the London Stock Exchange (LSE) might be slightly higher than those on US markets.
3. Average higher TER: It’s worth noting that the Total Expense Ratio (TER) of ETFs in Ireland is generally higher compared to those in the US.
While these tradeoffs are worth noting, the overall benefits of Irish Domiciled ETFs should not be overlooked. Their advantageous aspects, such as lower withholding taxes, exemption from substantial estate taxes, and the option of accumulating funds, contribute to a more cost-effective investment strategy over the long term.
Ireland ETF remains the best solution to avoid Withholding Taxes on Dividends for European Investors. If you not seeking for ETF the best solution are again the Ireland ETF (Accumulating).
US ETF are not efficient for our continent.
Site tip for Swiss investors:
- Swiss tax guide for investors in ETFs (USA, Europe, Ireland, etc.)
- Technical factors of ETF investing for tax-exempt investors