© 2010 Columbia Management Investment Advisers, LLC. All rights reserved.
One Financial Center, Boston, MA 02111-2621
Estimated total distributions from open-end mutual
funds (excluding money market funds) 2000-2009
($ millions)
Source: L...
In today’s rising tax environment, we believe that investors will
be better served by managers who understand the need t...
Return of S&P 500 Stocks by Dividend Policy
Source: Ned Davis Research, Inc., June 1985-June 2010
Dividend-paying stocks...
In reality, municipal bankruptcies have been very rare. Only
0.06% annually of all investment-grade municipal entities
Tax awareness
Plan ahead for new and higher taxes
A combination of tax-smart strategies can help you retain
wealth despi...
Under current law, the Bush tax cuts are set to expire for all taxpayers. Under the Obama administration’s proposals, ...
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Retaining Wealth in a Rising Tax Environment


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Retaining Wealth in a Rising Tax Environment

  1. 1. © 2010 Columbia Management Investment Advisers, LLC. All rights reserved. One Financial Center, Boston, MA 02111-2621 columbiamanagement.com 08/10 August 2010 Capital Insight PERSPECTIVES FROM COLUMBIA MANAGEMENT Retaining Wealth in a Rising Tax Environment Most experts agree that tax rates are on the rise, particularly for high-earning taxpayers. Tax cuts enacted during the Bush administration are slated to expire at year end and a debate is underway in Washington on whether they should be extended and if so, in what form. In addition, numerous states and municipalities have implemented, or plan to implement, new and/or higher taxes. This paper explores three opportunities to improve the tax efficiency of your investments despite potentially rising tax rates: > Short-term capital gains, while more easily avoided when you own shares outright, can also be minimized by investment managers. > Dividend-paying stocks can offer solid long-term total returns, especially if the income generated is “qualified” and, therefore, subject to a lower tax rate. > Municipal bonds are known for their tax efficiencies, but investing in these once-straightforward securities now requires greater expertise. Tax increases at a glance1 If, as expected, the Obama administration proposals are adopted and the Bush tax cuts expire on January 1, 2011, high- income taxpayers (married couples earning $250,000 or more and individuals earning $200,000 or more) will face higher tax rates on both earned and investment income. Unless there is action before year end, taxpayers will see: > An increase in the top income tax rates from 33% and 35% to 36% and 39.6%, respectively. > An increase in the top long-term capital gains tax rate from 15% to 20%. > A potential increase in the top tax rate on qualified dividends from 15% to 20% if Congress extends favorable treatment and ties it to the long-term capital gains rate, or to 39.6% if it does not. Moreover, to finance national health care reform, Congress and the president have approved additional taxes that are scheduled to take effect at the beginning of 2013. These include: > A 0.9% payroll tax on employment (or self-employment) compensation in excess of $200,000 ($250,000 for married couples filing jointly.) > A 3.8% Medicare surtax on certain net investment income for households with modified adjusted gross income (MAGI) in excess of $250,000 and individuals with MAGI of more than $200,000. In addition, as they struggle to balance budgets and find revenue sources, states such as California, Connecticut, New Jersey, New York, North Carolina and Oregon have already announced tax hikes. More states are likely to follow, especially if the federal stimulus package is not extended beyond 2010. Short-Term Gains More manageable than you may think Whether your goal is building long-term wealth or maintaining purchasing power in the face of inflation, equity investments can provide important growth potential. They can also have significant tax implications if not managed properly. Despite the investment losses in 2008, mutual funds distributed $16 billion in net short-term capital gains which are taxed as ordinary income. In 2009, short-term gain distributions decreased to $7.9 billion, the lowest payout in this half of the decade (see chart on next page). But, for the first time, they were higher than long-term gain distributions ($2.9 billion). In fact, for 2005–2009, mutual funds distributed $131.9 billion in short-term capital gains to investors, compared with $81 billion for 2000–2004. Given the rapid and near-historic market gains in 2009, a return to higher payouts may be in the offing for 2010.
  2. 2. 2 Estimated total distributions from open-end mutual funds (excluding money market funds) 2000-2009 ($ millions) Source: Lipper, a Thomson Reuters Company, December 2009 Tax implications Like regular income, net short-term capital gains are taxed at an investor’s ordinary income tax rate. The highest-income earners should be aware that the proposed maximum tax rate is 39.6% in 2011 (see table below). When an investment distributes short-term gains there can be significant tax implications. Source: Internal Revenue Service For example, assume an investor owns 100 shares of the XYZ Strategy, which is priced at $10 per share. At the close of business, XYZ distributes a $2 per share short-term capital gain. If the shareholder chooses to have all income and gains reinvested, the account value is calculated as follows: The above example is hypothetical. Managing short-term gain distributions Taxes cut into investment returns — whether they are triggered by short-term gains, long-term gains or ordinary income such as income from a taxable bond fund. On average over the past 10 years, it is estimated that equity fund investors gave up nearly a full percentage point of return each year due to taxes 4 (see next page, “Tax drag on equity returns”). In 2009 alone, investors paid approximately $736.2 million in short-term capital gains taxes, compared with $148.9 million in long-term capital gains taxes (for doing nothing more than holding the investment for a longer period of time). 5 While some taxable events are unavoidable, short-term capital gain distributions can be quite manageable. These distributions can be minimized if the investment manager takes certain deliberate actions: > Educate portfolio management teams on the significant value that can be retained by avoiding short-term gain distributions. > Incent the investment teams by tying a portion of their compensation to after-tax returns. > Invest in technology that helps the investment teams identify specific lots within position holdings that, when sold, will result in the best after-tax outcome for shareholders. $0 $100,000 $200,000 $300,000 $400,000 $500,000 $600,000 Short‐Term Cap Gains Long‐Term Cap Gains Income Distribution Return of Capital Total Initial value 100 shares x$10 per share $1,000 Amount to be reinvested 100 shares x$2 per share capital gain $200 Net asset value (NAV) on ex- dividend date $10 initial price - $2 distribution $8 Additional shares to the investor $200 reinvestment amount / $8 NAVper share 25 shares Account value on ex-dividend date 125 shares x$8 per share $1,000 Taxliability $200 short-term capital gain x0.35 (35% tax rate) $70 After-taxvalue $1,000 - $70 $930 Tax liability if the distribution were a long-term gain instead $200 long-term capital gain x 0.15 (15% tax rate) $30 After-tax value if the distribution were a long-term gain instead $1,000 - $30 $970 Distribution type Current maximum tax rate Scheduled maximum tax rate for 2011 OrdinaryDividend 35% 39.6% Qualified Dividend Distribution 15% 20%/39.6%3 Short-Term Capital Gain 35% 39.6% Long-Term Capital Gain 15% 20% Return of Capital Generallynot taxable Generallynot taxable Tax Rates on Distributions2
  3. 3. 3 In today’s rising tax environment, we believe that investors will be better served by managers who understand the need to minimize short-term capital gains distributions and have the incentives and technology in place to help portfolio management teams achieve the objectives in a tax-efficient way. Steps to take: > Look for strategies that manage short-term capital gain distributions. > Seek out investment managers who are incented to be tax-efficient. Dividend-Paying Stocks Opportunity for buy-and-hold investors Another opportunity for investors to build wealth, in spite of rising taxes, lies in dividend-paying stocks. However, this strategy works better if the stocks are held long enough for the dividend to be considered qualified. Qualified dividends are currently subject to a maximum 15% tax rate, but will likely be increasing to a 20% rate in 2011, if Congress extends the favorable tax treatment for qualified dividends and taxes them at the scheduled long-term capital gains rate. Nonqualified dividends are taxed at the investor’s ordinary income tax rate. In order for dividends to be considered qualified, the stock must be owned for more than 60 days during the 121-day period around the ex-dividend date. Quality counts Although many dividend-paying companies offer this potential tax advantage, dividend-paying stocks should be carefully scrutinized. Companies that consistently pay dividends and make a habit of raising them have historically outperformed the market, while companies that cut dividends have underperformed. A growing, sustainable dividend often means a company’s management team is wisely using free cash flow to return value to shareholders. This factors substantially into return and can act as a stabilizing force in volatile markets. The tax drag on equity returns According to Lipper, over the past 10 years, investors in equity funds have given up an average of 98 basis points (each basis point is equal to 1/100 of a percentage point of return) each year to taxes. 6 How does that translate into dollars? Consider a hypothetical $1 million investment in each of two strategies: > Strategy A earns the same returns as the S&P 500 but makes no distributions (that is, incurs no tax consequences for investors) > Strategy B makes average equity fund capital gains and dividend distributions Over the full 10-year period, investors in Strategy B would have paid $88,000 in taxes. Over the latest five-year period, the tax drag would have been $50,000. Clearly, strategies that carefully manage their distributions can add significant value for investors. 60 days 60 daysEx-dividend Own the stock for more than 60 consecutive days during this period, so that the dividend payment may qualify for the lower tax rate.
  4. 4. 4 Return of S&P 500 Stocks by Dividend Policy Source: Ned Davis Research, Inc., June 1985-June 2010 Dividend-paying stocks can be useful in building wealth in both the accumulation and distribution stages. These stocks can be a high-quality source of total return, especially when investors reinvest the dividends so they can compound over time. Likewise, the stocks can be a reliable source of income for retirees. Whether tax rates are going up or down, there can be a benefit to investing in quality, dividend-paying companies. Steps to take: > Look for equity strategies that invest in high-quality dividend-paying stocks. > Seek out investment managers who distribute qualified dividends whenever possible. Municipal Bonds Value of tax-free income is likely to rise Investment income that is not subject to taxation has widespread appeal, especially for retirees who maybe more dependent on the income provided by their investments. If, as expected, the maximum federal tax rate reverts to its pre-2002 level of 39.6% in January 2011, investors in the top tax bracket are likely to find the tax-exempt income provided by municipal bonds more valuable than in the past. Keep in mind that while interest income from municipal bonds is exempt from federal income tax, the interest on certain private activity bonds may be subject to alternative minimum tax. One way to see the value of tax-exempt income is to calculate Tax-Equivalent Yield (TEY), using different tax rates. The TEY compares what a taxable bond would have to yield in order to provide the same after-tax income as a tax-free bond. TEY can be readily calculated by dividing the yield of a municipal bond by one minus the tax rate. For example: States generally exempt municipal bond interest from state income taxes if the bond is issued by that state, its agencies or political subdivisions but tax the interest from out-of-state bonds. Special rules apply to bonds held in mutual funds. If the interest from the bonds is exempt from state taxes, the TEY is even higher. Stable asset class There is more to a municipal bond than its tax-exempt income. The credit quality of the issuing entity is also a critical factor. Municipal bonds are issued by cities, states or counties in order to raise funds, typically for long-term capital projects. In today’s economy, many municipalities are faced with growing deficits and demographic constraints. As a result, fears of widespread municipal bankruptcies have recently made their way into the media. $000 $500 $1000 $1500 Dividend Growers and Initiators: Annual Gain = 8.7% ($100 grows to $808) Annualized Standard Deviation =  15.93% Non Dividend‐Paying Stocks: Annual Gain = 0.5% ($100 grows to $114) Annualized Standard Deviation =  24.60% S&P 500 Geometric Equal‐Weighted Total Return Index: Annual Gain = 5.7% ($100 Grows To $402) Annualized  Standard Deviation = 18.01% Tax-free yield Federal tax rate7 Taxable equivalent yield (TEY) 4.00% 35% 6.15% 4.00% 39.6% 6.62%
  5. 5. 5 In reality, municipal bankruptcies have been very rare. Only 0.06% annually of all investment-grade municipal entities defaulted between 1970 and 2009. The municipal bankruptcy process is complex and differs considerably from corporate bankruptcy filings. Moreover, municipalities do not want to lose bond market access, which is viewed as a vital, low-cost method of funding government projects. When municipalities get into trouble, certain state mechanisms, such as fiscal control boards, can be better, less-costly alternatives to bankruptcy. As a result, municipal bankruptcies are far less common and damaging than corporate bankruptcies. Nevertheless, the municipal bond landscape has become more difficult to navigate. With more than 50,000 municipal bonds in the marketplace today, active professional management that includes diligent credit research, issue selection and monitoring, and stress testing, is more crucial than ever. A dedicated investment management team that conducts in-depth due diligence on its municipal securities may help you achieve better, less-volatile investment outcomes. Supply and demand in municipals The supply/demand balance is currently quite favorable for municipal bond investors. Although municipal supply rose considerably in 2009, the largest increase came from taxable municipal securities issued under the Build America Bonds (BABs) program. The BABs program offers governmental issuers a federal tax credit on the interest cost associated with issuing taxable municipals in place of tax-exempt bonds. The program was designed to lower the capital costs of municipal issuers by expanding the market for their tax-exempt bonds to buyers of taxable bonds. Consequently, supply was diverted from the tax-exempt market into the taxable market, as nearly $100 billion of $400 billion in total municipal issuance in 2009 was due to BABs. Overall, the combination of higher demand caused by increasing tax rates and lower supply resulting from the BABs program may result in good relative performance for municipal bonds. Steps to take: > Select municipal bond funds that are supported by diligent credit research. > Use investment managers who remain current on the dynamics of today’s municipal market. Build America Bonds issuance is anticipated to increase as it replaces a portion of tax-exempt bonds.
  6. 6. 6 Tax awareness Plan ahead for new and higher taxes A combination of tax-smart strategies can help you retain wealth despite rising taxes — whether you are building wealth or drawing it down: > Short-term capital gains can be virtually eliminated during normal equity markets. > Qualified dividends are subject to a lower tax rate through 2010 and potentially beyond. > Municipal securities can provide attractive tax-exempt income. Ask your financial advisor to help you take appropriate action now to keep you a step ahead of tax hikes and preserve more of your wealth. Tax-efficient strategies for life Accumulation phase investors are focused primarily on building wealth for later life goals. > Minimize short-term capital gains distributions when possible. > Invest in dividend-paying stocks through strategies that primarily distribute qualified dividends. Reinvest the dividends to benefit from compounding. > Consider municipal bond funds for assets that cannot be sheltered in tax-deferred accounts. Distribution phase investors are living off of the assets they have accumulated and typically need reliable sources of income. > Place equity assets in strategies that incent and equip their investment managers to minimize short-term capital gains distributions. > Consider dividend-paying stocks through strategies that make primarily qualified dividend distributions. > Invest in municipal bond funds through investment managers who conduct diligent credit research.
  7. 7. 7 1 Under current law, the Bush tax cuts are set to expire for all taxpayers. Under the Obama administration’s proposals, the tax cuts would only be allowed to expire for higher-income taxpayers to the extent they are in the highest two tax brackets (which would start at $250,000 less the standard deduction and two personal exemptions for married taxpayers filing jointly; $200,000 less the standard deduction and one personal exemption for single filers). 2 It is expected that the 39.6% rate will apply to individuals or married couples in 2011 with taxable incomes in excess of $373,650. 3 The maximum tax rate could be 20% if Congress extends favorable treatment of qualified dividends and ties it to the scheduled long-term capital gains rate, or 39.6% if favorable treatment is allowed to expire. 4 Source: Lipper, A Thomson Reuters Company. “Taxes in the Mutual Fund Industry — 2010: Assessing the Impact of Taxes on Shareholders’ Returns.” 5, 6 Ibid, 2009 7 The effective tax rate for individuals in the highest federal income tax bracket may be higher than the rates shown here once other tax factors are taken into account, for example, state and local income taxes, the phaseouts for personal exemptions and interest deductions (scheduled to reappear in 2011) and the new 3.8% Medicare surtax (scheduled to appear in 2013), etc. Investors should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. For a free prospectus, which contains this and other important information about the funds, visit columbiamanagement.com. Read the prospectus carefully before investing. The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate. Columbia Management Investment Advisers, LLC and its affiliates do not offer tax or legal advice. Consult with your tax advisor or attorney regarding your specific situation. On April 30, 2010, Ameriprise Financial, Inc., the parent company of RiverSource Investments, LLC, acquired the long-term asset management business of Columbia Management Group, LLC, including certain of its affiliates, which were, prior to this acquisition, part of Bank of America. In connection with the acquisition of the long-term assets, certain clients of Columbia Management Advisors, LLC have a new investment adviser, RiverSource Investments, LLC, which is now known as Columbia Management Investment Advisers, LLC. For those clients that use the services of a sub adviser, those arrangements are continuing unless notified otherwise. Source of chart data on page four: Ned Davis Research, 06/30/10. Based on equal-weighted geometric average of total return of dividend- paying and non-dividend-paying historical S&P 500 Index stocks, rebalanced annually. Uses annual dividends to identify dividend-paying stocks and changes on a calendar year basis. The performance shown represents the risk-return characteristics of each of the categories with annualized standard deviation (measure of risk) measured on the x-axis and average annualized return measured on the y-axis. Risk is represented by standard deviation, a statistical measure of performance fluctuations. Generally the higher the standard deviation, the greater the expected volatility of returns. Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value. Securities products offered through Columbia Management Investment Distributors, Inc. (formerly known as RiverSource Fund Distributors, Inc.), member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC (formerly known as RiverSource Investments, LLC).