Welcome and thanks for joining us today. Investors have real concerns on the impact taxes will have on their wealth, and are interested in solutions to help them meet their most important objectives in light of the impact of taxes: saving for retirement, funding college education, having enough income in retirement, and transferring wealth. During our session today we will examine the current income and estate tax landscape including a thorough review of legislation signed into law to avoid the so-called “fiscal cliff.”
Here are our topics for discussion today: First, we ’ll start by reviewing the key provisions of the American Taxpayer Relief Act of 2012 that broadly extended tax rates and provisions for the vast majority of taxpayers. Since new taxes related to health-care reform begin in 2013, we will review how those work. Although this new law brings clarity on taxes, as discussion in Washington continues on comprehensive tax reform, we will explore the key driving factors – rising budget deficits and entitlement program cost pressures that could ultimately lead to more tax-related changes in the future. Lastly, we will highlight specific, actionable planning ideas to consider in collaboration with a qualified tax or estate planning professional.
Let ’s start by reviewing important tax legislation passed by Congress on New Year’s day that addressed the so-called “fiscal cliff.”
In the early morning hours of January 1, the Senate voted 89-8 to pass the American Taxpayer Relief Act of 2012. Later that evening the House passed the legislation by a vote of 257-167 to send the bill to President Obama for his signature. The new law extends the Bush-era tax cuts for the vast majority of taxpayers on a permanent basis. Taxpayers with income greater than $400,000 ($450,000 for couples) are subject to a 39.6% marginal ordinary income tax rate and a 20% tax rate for long-term capital gains and qualified dividends. Many tax provisions (i.e., “extenders”) that expired in 2011 or were due to expire in 2012 were extended. The new law also: Restores income phase-outs for itemized deductions (the “Pease” limitation) and personal exemptions (the PEP or Personal Exemption Phase-out) for taxpayers with income over $250,000 ($300,000 for couples). Though this is effectively a tax increase, the phase-out for itemized deductions was slated to return at much lower income level — $177,550 according to the Tax Policy Center Permanently “patches” the AMT by indexing the exemption amount going forward Raises the maximum estate tax rate from 35% to 40% but prevents the rate from returning to maximum 55% in the case of a full sunset of previous tax law. The $5 million exemption amount (indexed for inflation) is extended permanently for estates, gifts, and generation skipping transfers. Emergency unemployment benefits are extended until the end of 2013 but the payroll tax holiday expires, resulting in an increase in the employee portion of the payroll tax from 4.2% to 6.2% (this tax applies only to the first $113,700 in wages and salary for 2013). Delays by two months the automatic spending cuts that were included within the Budget Control Act of 2011 from beginning in January. These cuts were projected to be approximately $1.2T over 10 years. Although there was some discussion on paring back the tax benefits of municipal bonds, the law does not change their tax-free status.
Here ’s a summary of the key income tax-related areas. Ordinary income : Clinton-era maximum tax rate of 39.6% is restored for taxpayers with more than $400,000 ($450,000 for couples). President Obama had previously called on a income threshold of $200K/$250K while there was a Republican proposal being considered in the House that would have established a threshold of $1 million. Capital gains and dividends : Maximum 20% rate for taxpayers above the $400K/$450K threshold. The 15% rate remains in place for taxpayers within the 25%, 28%, 33%, and 35% brackets while taxpayers in the lowest two income tax brackets (10% and 15%) benefit from a zero percent tax rate on long-term capital gains and qualified dividends. Itemized deductions and personal exemptions : Income phase-outs return for taxpayers at a $250K/$300K income threshold. Note that as income increases, some taxpayers may realize an 80% reduction in itemized deductions (mortgage interest, state and local property taxes, etc.) and a full elimination of their personal exemptions (e.e., dependent children). Alternative minimum tax (AMT): Since the exemption amount (basically the amount of income a taxpayer can exempt before AMT applies) was never indexed for inflation, Congress has passed a series of “patches” over the years to avoid a drastic expansion of the AMT to more taxpayers (from 5 million taxpayers to over 30 million taxpayers). For example, without any action for tax year 2012, the AMT exemption for a married couple would have reverted back to $45,000 — the same amount that was in place more than 10 years ago. The tax law changes the 2012 exemption amount to $78,750 ($50,600 for individuals) and indexes the amount in the future on permanent basis.
The new law extends most elements of the 2012 tax estate regime permanently. The $5 million exemption amount (indexed for inflation) for estates, gifts, and generation skipping transfers continues. For 2013, that figure is $5.25 million. The one change in the estate tax law is an increase in the maximum tax rate from 35% to 40%. However, this is still less than the rate (55%) that would have been in place with a full sunset of the law after 2012. Lastly, the provision allowing for portability of a deceased spouse ’s unused exemption amount is extended permanently. This provision was introduced within the legislation signed into law in late 2010 that extended the Bush-era tax cuts for two years.
Many expiring tax preference items and credits that recently expired or were due to expire were extended by the new law. Some key provisions include: Education-related items : The law extends the American Opportunity Tax Credit (up to $2,500) for 5 years. This tax credit is available to certain taxpayers – the credit phases out for single taxpayers between $80K and $90K of income, and between $160K and $180K for couples. The $2,000 contribution for Coverdell accounts is made permanent (was set to revert back to $500). The flexibility to use funds for K–12 expenses also continues. The above-the-line deduction for tuition expense is extended for 2013 – this is a maximum of $4,000 available to taxpayers (based on 2011 figures) whose AGI did not exceed $65,000 ($130,000 for couples). A limited $2,000 deduction was available for taxpayers with income not above $80,000 ($160,000 for couples). Lastly, a deduction for student loan interest is made permanent. The phase-out of this deduction begins at $60,000 in modified adjusted gross income ($120,000 for couples). Tax-free IRA distributions to a charity : Return for 2013 with a special transition rule applying to distributions which occurred in December 2012. IRA owners who took an IRA distribution in December 2012 may avoid taxes on that distribution (or a portion of the distribution) if they make a donation to a qualified charity before February 1, 2013. State/local sales tax : Option to deduct sales taxes instead of state income taxes is extended through 2013. This especially appeals to taxpayers who reside in states with no income tax. Marriage Penalty : Permanent fix means tax brackets and other allowances are adjusted for couples to be twice the amount of an individual taxpayer. For example, without a fix, the standard deduction for a couple would NOT be twice the amount for an individual taxpayer – it would be less.
Considering important changes related to the health-care reform law, let ’s take a look in more detail on provisions beginning in 2013.
In March 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act were signed into law, marking the most sweeping changes to our nation ’s health-care system in decades. Among other tax-related provisions, the law introduces an additional tax of 3.8% on net investment income such as interest, dividends, taxable annuity income, and capital gains. Income resulting from “passive” business activities may also be subject to the tax. For example, suppose an individual is a limited partner in a restaurant business but is not involved in the day-to-day operation of the business (i.e., not an active participant). This is considered passive activity, and resulting income could be subject to the 3.8% surtax. Income from retirement plan distributions (pensions, 401(k), IRAs, etc.) are excluded. Municipal bond interest income is also excluded. In addition, beginning in 2013 higher-income workers ($200,000 in salary/wages for individuals, $250,000 for couples) will be subject to an additional 0.9% tax on Medicare payroll tax (from 1.45% to 2.35%). Additional benefits for Roth IRAs and municipal bonds: Since income from Roth IRAs or municipal bonds is not included in AGI, income from these sources will not push taxpayers beyond the threshold ($200K for individuals, $250K for couples), potentially causing other income to be subject to the 3.8% surtax. However, even though distributions from Traditional IRAs (or income resulting from a Roth IRA conversion) are not subject to the surtax, a large RMD or conversion may push AGI above the $200K/$250K threshold, resulting in other investment income being subject to the tax.
Here ’s a quick illustration depicting how the 3.8% surtax works. In this (simplified) case, the married couple has $350,000 in total income including: $150,000 in salary $50,000 in IRA income (from a distribution) $100,000 long-term capital gain $50,000 in tax-free municipal bond income The incremental amount of the capital gain above the $250,000 income threshold is subject to the 3.8% surtax ($50K of the $100K capital gain in this example). Though the $50K in IRA income is not subject to the surtax, this income is included in the calculation of modified adjusted gross income (MAGI) toward the threshold. The municipal bond income is not subject to the surtax nor does this income contribute to the MAGI calculation with respect to the income threshold.
Now that we ’ve reviewed the fiscal cliff tax deal and provisions being implemented as part of health-care reform, let’s take a look at the big picture with respect to federal budget deficits, government spending, and the possibility of comprehensive tax reform.
Annual federal budget deficits have existed since the first part of the century but have risen dramatically in the past couple of years, largely affected by the global credit crisis. In fact, the annual deficit more than tripled from 2008 to 2009. For the past four fiscal years, the annual budget deficit has exceeded $1 trillion each year.
Here ’s another chart that further illustrates the deficit issue facing the federal government. Since 1970, tax revenue has averaged approximately 18% of GDP while government spending has averaged around 21%. Since 2008 this spread has widened dramatically because of historic low tax revenues and rising government spending due to the recession. In order to solve the longer-term budget deficit problem, the spread between revenue and spending will have to converge.
Though the recent tax deal largely avoided the “fiscal cliff” scenario, legislation to extend tax rates for most Americans will exacerbate the deficit problem. According the Congressional Budget Office (CBO), the American Taxpayer Relief Act of 2012 will add almost $4 trillion in total to the deficit over the next 10 years.
Let ’s take a deeper dive into government spending. Mandatory spending consists primarily of benefit programs, such as Social Security, Medicare, and Medicaid. The Congress generally determines spending for those programs by setting rules for eligibility, benefit formulas, and other parameters rather than by appropriating specific amounts each year. For our example, we are including interest payments on existing debt in the mandatory category. Discretionary spending is controlled by annual appropriation acts; policymakers decide each year how much money to provide for given activities. Appropriations fund a broad array of government activities, including those involved with defense, law enforcement, and transportation, for example. They also fund the national park system, disaster relief, and foreign aid. Since the majority of spending is tied to mandatory sources, it will be difficult for the federal government to solve its deficit problem simply by reigning in spending without addressing entitlement programs like Social Security and Medicare. Some interesting statistics on the current level of spending: Total mandatory spending for 2012 = $2,475B; of that total, spending for Social Security is $772B and Medicare is $478B Social Security = 31% of mandatory spending and 20% of overall spending while Medicare = 19% of mandatory spending and 13% of overall spending Total discretionary spending is $1,318B of which Defense equals $708B (54% of discretionary spending,19% of overall spending) and non-defense is $609B (46% of discretionary spending, 16% of overall spending)
A longer-term debt solution will undoubtedly include a mix of different strategies including increased revenues, potential tax reform, cuts in discretionary spending, and entitlement reform. As more baby boomers retire, there will be increased cost pressures on Social Security and Medicare. In fact, according the latest trustee ’s report, the Social Security trust fund reserves will be exhausted by 2033, resulting in a sharp decline (by approximately 25%) in benefits. There are a number of different proposals being considered to strengthen the fiscal health of Social Security. In general, most proponents of “tax reform” call for simplification through a combination of fewer (and presumably lower) marginal tax rates and an elimination or sharp reduction in tax preference items. Here’s a little detail on the Bowles-Simpson plan: Bowles-Simpson plan President Obama created the commission in February 2010 to address the nation ’s fiscal situation by “identifying policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run.” The commission, co-chaired by former Chief of Staff to President Clinton Erskine Bowles and former Senator Alan Simpson (R-WY), recommended over $4 trillion in long-term deficit reduction, composed of approximately $3 trillion in spending cuts and $1 trillion in increased tax revenues. In addition to individual tax-related provisions, the Bowles-Simpson plan calls for similar changes to the corporate tax system. The 2012 top tax rate of 35% would be reduced to 28%, but many tax preference items would be reduced or eliminated. To strengthen Social Security, the proposal recommends an increase in the Social Security wage base to cover 90% of wages (approximately 85% of wages are currently taxed), a gradual increase the retirement age, and a change in the formula for calculating cost of living adjustments (COLA).
We ’ve covered the broad tax landscape for 2013 and have examined key factors driving the nation’s budget deficit – let’s shift our focus to planning for income and estate taxes in light of the current tax environment.
Invest in municipal bonds : As we transition from 2012 to 2013, municipal bonds become more attractive on a relative tax basis for taxpayers who find themselves subject to the 3.8% surtax and who may also be subject to the highest (39.6%) marginal rate. Reduce/avoid taxable income : These are not new strategies. However, considering the income thresholds for the 3.8% surtax ($200K/$250K), phase-outs of deductions ($250K/$300K), and the highest marginal tax rate ($400K/$450K), there is a premium on utilizing all available strategies to reduce taxable income, including increasing/ maximizing retirement plan contributions and IRAs, tactical use of deferred compensation programs, FSAs, HSAs, etc. Although taxes remain the same for almost all taxpayers on a “permanent” basis, it’s conceivable that changes could occur as in the context of deficit reduction in the near future. It’s very difficult to predict the future of tax rates and policy. Holding a portion of retirement savings inside a Roth IRA can act as a hedge against the direction of future tax rates or a taxpayer’s own tax circumstances. The 2012 law further expands Roth, and ALL participants in 401(k) can potentially convert traditional (i.e., pretax) funds to a Roth 401(k), assuming the plan offers a Roth 401(k) option and has also added the conversion feature.
Tax-free IRA distributions : This provision returns for 2013 (with a special rule for December 2012 IRA distributions). IRA owners must be over the age of 70½, and the distribution (maximum of $100K annually) must be sent directly to a qualified charity. For many taxpayers, it is more tax-efficient to transfer IRA assets tax free to a charity then to write a check to a charity and claim a deduction on the tax return (see Donating IRA Assets to a Charity for more details). Review documents: The permanency of the historically high $5M exemption amount may have unintended consequences for some individuals who have wealth under that threshold and who may perceive that they don ’t have to plan for their estate. Clearly, taxes are just one issue. Investors still have to plan for orderly transition of assets, plan for unforeseen circumstances, etc. This is an opportunity to engage investors to make sure the fundamental documents and designations are in place. There are a number of states that are not tied to the federal estate tax system and may have lower exemption amounts or different laws around estate or inheritance taxes that must be accounted for. For example, NY has an exemption amount of $1 million and NJ has an exemption amount of only $675,000.
Advanced wealth strategies : There has been increased scrutiny among lawmakers on these more complex techniques. High-net-worth individuals and families should seek counsel from an estate planning attorney to determine if any of these strategies are an appropriate option for transferring wealth efficiently.
Significant changes may be on the horizon for 2013, and investors would be well served to keep a close eye on how these changes will impact their personal finances. The best preparation is to consult with a financial advisor or tax professional, who can offer some perspective on your specific financial and tax situation, help you understand the risks, and position your assets accordingly. The markets and the regulatory environments are always changing, and in uncertain times like these, sound financial advice should be at the foundation of any long-term investment strategy.
Now that we have reviewed how you as an investor may benefit from investing in bonds, I want to tell you about how to pursue opportunities with Putnam Investments. Putnam has been helping people pursue their financial goals — including managing portfolios of bonds — since 1937. The company uses the same prudent approach to manage all its funds. And although there is no guarantee a fund will meet its objectives, every fund strives to deliver performance that is consistent, dependable, and superior over time. Putnam primarily uses a fundamental, “ kick-the-tires ” research approach for each of its funds. At Putnam, our seasoned portfolio managers look at all of these factors and try to reduce risk by utilizing as many opportunities as they can rather than concentrating their investment dollars in one or two areas. Just as investors should diversify their fund holdings, portfolio managers at Putnam diversify their holdings to try to own more opportunity and less risk.
Taxes after the fiscal cliff: Planning opportunities in 2013
Not FDIC May Lose No Bank Insured Value Guarantee EO191 279601 1/13 |1
Topics for today• New tax legislation avoids the fiscal cliff• Health-care reform law introduces two new taxes beginning in 2013• Longer-term outlook on taxes• Tax-smart planning considerations and strategies EO191 279601 1/13 |2
The American Taxpayer Relief Act of 2012• Bush-era tax cuts extended permanently for most taxpayers• Many popular tax provisions extended• Benefit of tax deductions reduced for some• Alternative minimum tax (AMT) permanently indexed for inflation• Emergency unemployment benefits extended but payroll tax reverts to 6.2% EO191 279601 1/13 |4
Taxes increase for sometaxpayersOrdinary income Taxpayers with taxable income above $400K ($450K for couples) subject to a marginal tax rate of 39.6%Dividends and capital Taxpayers at same $400K/$450K incomegains threshold subject to a 20% tax rate (0% rate still applies for lowest two brackets, 15% rate for others below the new threshold)Itemized deductions Income phase-outs return for taxpayers withand personal more than $250K in AGI ($300K for couples)exemptionsAlternative minimum Exemption amount for 2013 is $50,600tax (AMT) ($78,750 for couples) EO191 279601 1/13 |5
Clarity on the federal estate taxExemption amount $5 million amount for estates and gifts is made permanent and indexed for inflation ($5.25M for 2013)Maximum tax rate Increases from 35% in 2012 to 40%Portability Provision that allows a surviving spouse to utilize a deceased spouse’s unused exemption is made permanent EO191 279601 1/13 |6
Many tax provisions extended at least through 2013• Relief for families funding college education – American Opportunity Tax Credit, deduction for tuition expense, student loan interest deduction all extended – Contribution for Coverdell Savings Accounts set at $2,000• Tax-free IRA distributions to a qualified charity returns• Deduction for state & local sales taxes extended for 2013• Permanent fix for the “marriage penalty” EO191 279601 1/13 |7
New taxes associated with health-care EO191 279601 1/13 |8
New health-care taxes take effect in 2013• Affects taxpayers with more than $200,000 in income ($250,000 for couples)• Increase in the individual portion of the Medicare payroll tax on wages from 1.45% to 2.35%• New Medicare net investment income surtax of 3.8% – Interest, dividends, capital gains, rental income, passive business income all subject to the new tax – Interest from municipal bonds and distributions from retirement accounts are excluded The threshold for the 3.8% net investment income surtax is based on modified adjusted gross income (MAGI), defined as adjusted gross income plus net foreign income exclusion amount. The extra .9% Medicare payroll tax is based on earned income only (salary, wages, etc.). EO191 279601 1/13 |9
Married couple with income over $250K:How does the new 3.8% surtax work? $50K Not subject to 3.8% surtax Muni income $100K $50K cap gain subject to surtax$250K incomethreshold (MAGI) Cap gain $50K cap gain not subject to surtax $50K Not subject to the surtax but is included IRA income in determining the $200K/$250K income threshold $150K SalarySimplified, hypothetical example designed to illustrate how the new Medicare net investment income surtax is applied. Beginning in 2013, thesurtax applies to individuals with MAGI over $200,000 and married couples filing joint tax returns with MAGI over $250,000. MAGI defined asAdjusted Gross Income (AGI) plus net foreign income exclusion amount. EO191 279601 1/13 | 10
Longer-term outlookon the federal budget deficit and taxes EO191 279601 1/13 | 11
Federal budget deficit exceeds$1T for the fourth straight yearAnnual U.S. federal budget surplus/deficit, 2000–2012 ($B)($) 500 0 -500-1,000 -1,500 08 10 01 11 06 09 04 02 03 00 12 05 07 20 20 20 20 20 20 20 20 20 20 20 20 20Source: Congressional Budget Office, Monthly Budget Review, September 2012. EO191 279601 1/13 | 12
Spending is high and taxes are lowrelative to historical averages Historical federal tax receipts and government spending (% of GDP), 1970–2012 25% Current spending: 24%Percentage of GDP Historic spending: 21% 20% Historic taxes: 28% Current taxes: 15% 15% 1970 2012Source: Office of Management and Budget, 2012, historical figures are averages since 1970. EO191 279601 1/13 | 13
New tax deal projected toincrease the deficitEstimate of the Budgetary Effects the American Taxpayer Relief Actof 2012, 2013–2022FY ($B)$ 500 0-500 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022Source: Congressional Budget Office, January 2013. Estimate based on current law baseline assumption that the Bush era tax cuts would have fullyexpired after 2012. EO191 279601 1/13 | 14
The majority of governmentspending is on auto-pilotU.S. federal government spending by type, 2012 estimated Social Security Defense Discretionary 35% $773B $709B Medicare Non-Defense $478B $610BMandatory65% Medicaid $255B Interest Other $223 $670BSource: Source: Office of Management and Budget, September 2012. Mandatory spending types primarily include Social Security, Medicare, andMedicaid, as well as interest on existing debt. Discretionary spending includes defense and non-defense items. EO191 279601 1/13 | 15
What would a longer-term debt solution look like?• Everything on the table — increased revenues, cuts in discretionary spending, major entitlement reform• Thoughts on reforming Social Security – Increase the wage base* – Increase the retirement age for younger workers – Utilize a different COLA formula for benefit increases – Reduce benefits for higher-income recipients (i.e., means testing)• Comprehensive tax reform? – Less brackets and lower marginal tax rates, coupled with the elimination or significant reduction in tax preference items * Social Security wage base for 2013 is $113,700. EO191 279601 1/13 | 16
Planning considerations and strategies EO191 279601 1/13 | 17
Five planning strategies to consider in 20131. Invest in municipal bonds to generate tax-free income – Municipal bonds are more attractive for taxpayers who are either subject to 3.8% surtax and potentially the high 39.6% marginal rate1. Utilize strategies to reduce or avoid taxable income – Retirement plan contributions, flexible spending accounts (FSAs), deferred compensation may prevent a taxpayer from reaching income thresholds that may result in a higher tax bill – Be mindful of transactions that may drastically increase income – Consider Roth accounts to create tax-free income in retirement EO191 279601 1/13 | 18
Five planning strategies to consider in 2013. Avoid taxes on IRA distributions by using a charitable rollover if over the age of 70½ – Distribution (maximum of $100,000 annually) must be sent directly to a qualified charity – More tax efficient than writing a check to a charity and then claiming a deduction on the tax return4. Review estate planning strategies and documents – Even if estate taxes no longer a concern, it’s critical to plan for orderly transfer of assets or unforeseen circumstances – Many states have separate estate or inheritance taxes – Trusts should be reviewed in light of permanent $5M exemption amount EO191 279601 1/13 | 19
Five planning strategiesto consider in 20125. Consult with an attorney to see if more complex wealth transfer techniques may be appropriate – Families with significant wealth, especially in non-liquid assets such as real estate or closely held businesses – Potential strategies include grantor retained annuity trusts (GRATs), spousal lifetime access trusts (SLATs), family limited partnerships (FLPs), and dynasty trusts EO191 279601 1/13 | 20
Closing thoughts• Though the Bush-era tax cuts were extended “permanently” for most taxpayers, longer-term deficit pressures will prompt more discussion on taxes• There will likely be uncertainty around tax policy as potential tax reform is addressed• In this environment, tax diversification and tax-smart planning strategies and investment solutions will be at a premium EO191 279601 1/13 | 21
A BALANCED APPROACHA WORLD OF INVESTINGA COMMITMENT TO EXCELLENCE EO191 279601 1/13 | 22
This information is not meant as tax or legal advice.Please consult your legal or tax advisor before making any decisions.Investors should carefully consider the investment objectives, risks, charges, and expenses of afund before investing. For a prospectus, or a summary prospectus if available, containing thisand other information for any Putnam fund or product, call your financial representative or callPutnam at 1-800-225-1581. Please read the prospectus carefully before investing.Putnam Retail Managementputnam.com EO191 279601 1/13 | 23