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Retaining Wealth in a Rising Tax Environment

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Retaining Wealth in a Rising Tax Environment Retaining Wealth in a Rising Tax Environment Document Transcript

  • August 2010 Capital Insight PERSPECTIVES FROM COLUMBIA MANAGEMENT Retaining Wealth in a Rising Tax These include: > A 0.9% payroll tax on employment (or self-employment) Environment compensation in excess of $200,000 ($250,000 for married couples filing jointly.) Most experts agree that tax rates are on the rise, particularly for high-earning taxpayers. Tax cuts enacted during the Bush > A 3.8% Medicare surtax on certain net investment income for households with modified adjusted gross income (MAGI) administration are slated to expire at year end and a debate is in excess of $250,000 and individuals with MAGI of more underway in Washington on whether they should be extended than $200,000. and if so, in what form. In addition, numerous states and municipalities have implemented, or plan to implement, new In addition, as they struggle to balance budgets and find and/or higher taxes. This paper explores three opportunities to revenue sources, states such as California, Connecticut, New improve the tax efficiency of your investments despite Jersey, New York, North Carolina and Oregon have already potentially rising tax rates: announced tax hikes. More states are likely to follow, especially if the federal stimulus package is not extended beyond 2010. > Short-term capital gains, while more easily avoided when you own shares outright, can also be minimized by Short-Term Gains investment managers. > Dividend-paying stocks can offer solid long-term total More manageable than you may think returns, especially if the income generated is “qualified” and, Whether your goal is building long-term wealth or maintaining therefore, subject to a lower tax rate. purchasing power in the face of inflation, equity investments > Municipal bonds are known for their tax efficiencies, but can provide important growth potential. They can also have investing in these once-straightforward securities now significant tax implications if not managed properly. requires greater expertise. Despite the investment losses in 2008, mutual funds distributed $16 billion in net short-term capital gains which are taxed as Tax increases at a glance1 ordinary income. In 2009, short-term gain distributions If, as expected, the Obama administration proposals are decreased to $7.9 billion, the lowest payout in this half of the adopted and the Bush tax cuts expire on January 1, 2011, high- decade (see chart on next page). But, for the first time, they income taxpayers (married couples earning $250,000 or more were higher than long-term gain distributions ($2.9 billion). In and individuals earning $200,000 or more) will face higher tax fact, for 2005–2009, mutual funds distributed $131.9 billion in rates on both earned and investment income. Unless there is short-term capital gains to investors, compared with $81 billion action before year end, taxpayers will see: for 2000–2004. Given the rapid and near-historic market gains > An increase in the top income tax rates from 33% and 35% in 2009, a return to higher payouts may be in the offing for to 36% and 39.6%, respectively. 2010. > 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. © 2010 Columbia Management Investment Advisers, LLC. All rights reserved. One Financial Center, Boston, MA 02111-2621 columbiamanagement.com 08/10
  • Estimated total distributions from open-end mutual For example, assume an investor owns 100 shares of the XYZ funds (excluding money market funds) 2000-2009 Strategy, which is priced at $10 per share. At the close of ($ millions) business, XYZ distributes a $2 per share short-term capital gain. If the shareholder chooses to have all income and gains $600,000 reinvested, the account value is calculated as follows: $500,000 $400,000 Initial value 100 shares x $10 per share $1,000 $300,000 Amount to be reinvested 100 shares x $2 per share capital gain $200 $200,000 Net asset value (NAV) on ex- $100,000 dividend date $10 initial price - $2 distribution $8 $0 Additional shares to the investor $200 reinvestment amount / $8 NAV per share 25 shares Account value on ex-dividend date 125 shares x $8 per share $1,000 $200 short-term capital gain x 0.35 (35% tax Tax liability rate) $70 After-tax value $1,000 - $70 $930 Short‐Term Cap Gains Long‐Term Cap Gains Tax liability if the distribution were $200 long-term capital gain x 0.15 (15% tax a long-term gain instead rate) $30 Income Distribution Return of Capital After-tax value if the distribution Total were a long-term gain instead $1,000 - $30 $970 The above example is hypothetical. Source: Lipper, a Thomson Reuters Company, December 2009 Managing short-term gain distributions Taxes cut into investment returns — whether they are triggered Tax implications by short-term gains, long-term gains or ordinary income such Like regular income, net short-term capital gains are taxed at as income from a taxable bond fund. On average over the past an investor’s ordinary income tax rate. The highest-income 10 years, it is estimated that equity fund investors gave up 4 earners should be aware that the proposed maximum tax rate nearly a full percentage point of return each year due to taxes is 39.6% in 2011 (see table below). When an investment (see next page, “Tax drag on equity returns”). In 2009 alone, distributes short-term gains there can be significant tax investors paid approximately $736.2 million in short-term capital implications. gains taxes, compared with $148.9 million in long-term capital gains taxes (for doing nothing more than holding the investment 5 Tax Rates on Distributions2 for a longer period of time). Scheduled While some taxable events are unavoidable, short-term capital Current maximum maximum tax rate gain distributions can be quite manageable. These distributions Distribution type tax rate for 2011 can be minimized if the investment manager takes certain Ordinary Dividend 35% 39.6% deliberate actions: Qualified Dividend Distribution 15% 20%/39.6%3 > Educate portfolio management teams on the significant Short-Term Capital Gain 35% 39.6% value that can be retained by avoiding short-term gain distributions. Long-Term Capital Gain 15% 20% > Incent the investment teams by tying a portion of their Generally not Generally not compensation to after-tax returns. Return of Capital taxable taxable > Invest in technology that helps the investment teams identify Source: Internal Revenue Service specific lots within position holdings that, when sold, will result in the best after-tax outcome for shareholders. 2
  • In today’s rising tax environment, we believe that investors will Dividend-Paying Stocks be better served by managers who understand the need to minimize short-term capital gains distributions and have the Opportunity for buy-and-hold investors incentives and technology in place to help portfolio Another opportunity for investors to build wealth, in spite of management teams achieve the objectives in a tax-efficient rising taxes, lies in dividend-paying stocks. However, this way. strategy works better if the stocks are held long enough for the dividend to be considered qualified. Qualified dividends are Steps to take: currently subject to a maximum 15% tax rate, but will likely be > Look for strategies that manage short-term capital gain increasing to a 20% rate in 2011, if Congress extends the distributions. favorable tax treatment for qualified dividends and taxes them > Seek out investment managers who are incented to be at the scheduled long-term capital gains rate. Nonqualified tax-efficient. 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 The tax drag on equity returns around the ex-dividend date. According to Lipper, over the past 10 years, investors in equity funds have given up an 60 days Ex-dividend 60 days average of 98 basis points (each basis point is equal to 1/100 of a percentage point of return) 6 each year to taxes. How does that translate into dollars? Consider a hypothetical $1 million Own the stock for more than 60 consecutive days investment in each of two strategies: during this period, so that the dividend payment may qualify for the lower tax rate. > Strategy A earns the same returns as the S&P 500 but makes no distributions (that is, incurs no tax consequences for investors) Quality counts Although many dividend-paying companies offer this potential > Strategy B makes average equity fund tax advantage, dividend-paying stocks should be carefully capital gains and dividend distributions scrutinized. Companies that consistently pay dividends and make a habit of raising them have historically outperformed Over the full 10-year period, investors in Strategy the market, while companies that cut dividends have B would have paid $88,000 in taxes. Over the underperformed. A growing, sustainable dividend often means latest five-year period, the tax drag would have a company’s management team is wisely using free cash flow been $50,000. Clearly, strategies that carefully to return value to shareholders. This factors substantially into manage their distributions can add significant return and can act as a stabilizing force in volatile markets. value for investors. 3
  • Return of S&P 500 Stocks by Dividend Policy $1500 $1000 $500 $000 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% Source: Ned Davis Research, Inc., June 1985-June 2010 subject to alternative minimum tax. One way to see the value of tax-exempt income is to calculate Tax-Equivalent Yield (TEY), Dividend-paying stocks can be useful in building wealth in both using different tax rates. The TEY compares what a taxable the accumulation and distribution stages. These stocks can be bond would have to yield in order to provide the same after-tax a high-quality source of total return, especially when investors income as a tax-free bond. TEY can be readily calculated by reinvest the dividends so they can compound over time. dividing the yield of a municipal bond by one minus the tax rate. Likewise, the stocks can be a reliable source of income for For example: retirees. Whether tax rates are going up or down, there can be Federal Taxable equivalent a benefit to investing in quality, dividend-paying companies. Tax-free yield tax rate7 yield (TEY) Steps to take: 4.00% 35% 6.15% > Look for equity strategies that invest in high-quality 4.00% 39.6% 6.62% dividend-paying stocks. States generally exempt municipal bond interest from state > Seek out investment managers who distribute qualified income taxes if the bond is issued by that state, its agencies or dividends whenever possible. 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 Municipal Bonds even higher. Stable asset class Value of tax-free income is likely to rise There is more to a municipal bond than its tax-exempt income. Investment income that is not subject to taxation has The credit quality of the issuing entity is also a critical factor. widespread appeal, especially for retirees who maybe more Municipal bonds are issued by cities, states or counties in order dependent on the income provided by their investments. If, as to raise funds, typically for long-term capital projects. In today’s expected, the maximum federal tax rate reverts to its pre-2002 economy, many municipalities are faced with growing deficits level of 39.6% in January 2011, investors in the top tax bracket and demographic constraints. As a result, fears of widespread are likely to find the tax-exempt income provided by municipal municipal bankruptcies have recently made their way into the bonds more valuable than in the past. Keep in mind that while media. interest income from municipal bonds is exempt from federal income tax, the interest on certain private activity bonds may be 4
  • In reality, municipal bankruptcies have been very rare. Only Build America Bonds issuance is anticipated to 0.06% annually of all investment-grade municipal entities increase as it replaces a portion of tax-exempt bonds. 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. Overall, the combination of higher demand caused by increasing tax rates and lower supply resulting from the BABs Supply and demand in municipals program may result in good relative performance for municipal The supply/demand balance is currently quite favorable for bonds. municipal bond investors. Although municipal supply rose considerably in 2009, the largest increase came from taxable Steps to take: municipal securities issued under the Build America Bonds > Select municipal bond funds that are supported by (BABs) program. The BABs program offers governmental diligent credit research. issuers a federal tax credit on the interest cost associated with > Use investment managers who remain current on the issuing taxable municipals in place of tax-exempt bonds. The dynamics of today’s municipal market. 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. 5
  • Tax-efficient strategies for life Tax awareness Plan ahead for new and higher taxes Accumulation phase investors are focused A combination of tax-smart strategies can help you retain primarily on building wealth for later life goals. wealth despite rising taxes — whether you are building wealth or drawing it down: > Minimize short-term capital gains distributions when possible. > Short-term capital gains can be virtually eliminated during normal equity markets. > Invest in dividend-paying stocks through > Qualified dividends are subject to a lower tax rate through strategies that primarily distribute 2010 and potentially beyond. qualified dividends. Reinvest the > Municipal securities can provide attractive tax-exempt dividends to benefit from compounding. income. > Consider municipal bond funds for assets Ask your financial advisor to help you take appropriate action that cannot be sheltered in tax-deferred now to keep you a step ahead of tax hikes and preserve more accounts. of your wealth. 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. 6
  • 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). 7