Destination:Tax-Smart InvestingStrategies to Help You Keep More of WhatYou MakeIn the late 1990s, mutual fund asset values skyrocketed, generatingsignificant capital gains for investors. So when the tech bubble burst in theearly 2000s, and these gains were reported to the IRS as part of routineyear-end reporting, some investors found themselves in the unfortunateposition of losing money AND owing taxes.Could this scenario repeat itself?Given the likelihood of major changes in the federal tax code in the future– and with the exhaustion of tax-loss carryforwards – investors could onceagain face the possibility of less-than-ideal tax management.Taxes – especially when not managed properly – can erode investmentgains and minimize progress towards your financial goals. And uncertaintyaround taxes can add to your psychological discomfort as well as increasethe potential to make the wrong decisions.In times like these, every investor needs to examine and possibly rethinkinvestment tax management. So this article will discuss:›› The evolving tax code and what it means for you,›› Why investors may well be paying more taxes than necessary, and most importantly,›› The tools available to fight uncertainty and help you keep more of what you make – in any market environment.
Postponing the Inevitable? How Much Damage Could Be Done?This being an election year, the forecast is that there will It’s important to keep in mind the impact of taxes onbe major changes to the tax code next year but the actual hard-won investment gains. According to the Investmentchanges are hard to forecast. Let us instead deal with what Company Institute (ICI), at year-end 2008 more than 92is certain. The current Federal Income Tax rates are set to million shareholders (82% individuals, 18% institutions)expire at the end of 2012. Starting January 1, 2013 several owned the majority of the $9.6 trillion assets invested intax changes take effect including*: mutual funds that year.1 These investors paid approximately $736 million in 2009 due to short-term capital gains taxes,›› The top marginal income tax bracket will move to 39.6%, $149 million in long-term capital gains taxes and $12 billion up from 35%. because of taxes on dividends. Basically, these investors on›› The long-term capital gain rate will move to 20%, up from average gave up almost one percent (0.98%) of earnings to 15%. taxes. And while those numbers are disturbing, they came›› Dividends would no longer have any preferential tax in a year when the tax burden was relatively light. Finally, treatment which currently exists for “qualifying dividends” consider that those taxes covered little more than holding›› Two new taxes will come into play as a result of The the fund and reinvesting gains, essentially a buy-and-hold Patient Protection and Affordable Care Act (PPACA) strategy. –– The Medicare tax rate on households with earned Here’s another way to assess the damage of taxes. A income over $250k will be increased from 1.45% to hypothetical $100,000 portfolio invested in 60% stocks and 2.35%. The same increase will occur for singles with 40% bonds in 1979 would have grown to $3.17 million before earned income over $200k. taxes by 2011. However, with no efforts to mitigate the tax –– A new Medicare tax will be introduced for the same effect, Uncle Sam would have eaten almost 49 percent of group on investment income at a rate of 3.8%. The the gain, lowering the investor’s wealth to just over $1.6 Surtax applies to: taxable interest, dividends, capital million.2 gains, passive activity income, rents, royalties, and annuities.›› The reduction to the social security tax rate is restored to 6.2%, currently at 4.2%.›› The currently favorable estate & gift tax laws expire at the end of 2012. The estate and gift tax exemption moves down to $1M with a 55% maximum tax rate. Currently there is a $5M exemption and a 45% maximum tax rate.** Source: Parametric Portfolio Associates: 60% Russell 3000; 40% Barclays Capital Aggregate; No Liquidation. Interest income and dividends are taxed annually at historical topmarginal tax rates; capital gains are realized at 50% per year and are taxed at the historical long-term capital gains tax rate at the time. Past performance is no guarantee of futureresults.**A hypothetical $100,000 portfolio before taxes (invested 60% in stocks and 40% in bonds) held for 33 years would have grown to about $3.2 million. If the portfolio was taxed likean average mutual fund, it would have lost 49% of its value, due to taxes paid and earnings lost on that money. Tax-managed investment strategies are designed to minimize capitalgains distributions and enhance after-tax returns. As of 12/31/11. Since inception 12/2002. There is no guarantee that distributions will not be made in the future.
It’s Not What You Make, It’s What You Keep Taxes Reduce Performance Over Time Hypothetical Growth of $100,000** $3,500,000.00 49% Lost to Taxes Before-Tax Portfolio: $3,174,000 $3,000,000.00 $2,500,000.00 $2,000,000.00 $1,500,000.00 $1,000,000.00 $500,000.00 After-Tax Portfolio: $1,613,000 $0.00 1979 1987 1995 2003 2011Out With the Old, In With the New Parametric’s Langstraat believes that “Investors need a consistent, systematic, year-round approach to tax“Taxes take an enormous bite out of an investor’s return management in their portfolios.” However, there are minimal– but the good news is that you can do something about opportunities with traditional mutual funds, where taxit,” said Brian Langstraat, president of Parametric Portfolio management is mostly limited to deferring capital gains orAssociates, whose firm helps investment managers minimizing dividend distributions.implement tax management strategies. Parametricimplements a tax overlay structure within SEI’s Separate More to the point, the manager of a traditional mutual fundAccount program. buys and sells securities with the interests of the fund in mind, and not necessarily the tax consequences of theHistorically, according to Langstraat, most investors and investor. It’s for this reason that we offer tax-managed fundstheir financial advisors have focused only on cutting taxes in and tax-efficient separate account strategies.November and December or only in years where investorshave capital gains.Firms like Parametric argue that there is a better way to Tools to Ease Your Uncertaintyhelp protect the investor’s return throughout the market’s The list of tools available to managers of tax-managedups and downs. It begins with the admission that tax portfolios and other tax-advantaged investments reflectsmanagement cannot be a part-time endeavor. Given the their growing popularity. Think of each as navigational toolspotential damage of overpayment, the management of taxes to help the investor stay on course to his or her investmentmust be a cornerstone of an investor’s planning process. goal. While none of these tools are guaranteed, they can beIt calls for employing new techniques and strategies from very helpful in managing tax consequences:investment managers and more sensitivity to the tax Tax-lot accounting: A method of accounting for a securitiesconsequences of portfolio implementation. portfolio in which the manager tracks the purchase, sale“Investment return is number-one, tax management is price and cost basis of each security. This allows theone-A,” said Steve Konopka, Director, Investment Services manager to “swap” a batch of stocks with long-term gainswith SEI. Konopka admits to being frustrated when investors for a batch with smaller, short-term gains.and their advisors ignore tax management until year-end, at Loss harvesting: Allows the manager holding a stock at awhich point options are limited. loss to sell all or part of it to realize the loss and create an“If the investor only does tax management at year-end and “asset” that may help offset some future gain.the market went up, there’s not much that can be done at Wider rebalancing ranges: A wider rebalancing rangethat point,” he said. “But managing taxes throughout the can help reduce the number of trades made to keep theyear means the investor can take advantage of the ups and investor’s portfolio within a range of the target allocation,downs of the market and benefit from that volatility.” say a 60% equity and 40% bond allocation, which may lead