Strategies to Manage the Ever Bigger Bite of Taxes

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1 Tax Impact Series: Avoid Manage Defer AMG Funds Research and Analysis Strategies to Manage the Ever Bigger Bite of Taxes In this world, nothing can be said to be certain except death and taxes. Benjamin Franklin While credit is due to Ben Franklin for his oft-repeated words of wisdom, we humbly believe that he is only mostly correct. We will not dispute his claim regarding the certainty of death, but we believe it is worth taking a critical look at his pronouncement about taxes. When it comes to personal investments, taxes remain a huge consideration. The burden of taxes, however, can often be avoided, managed or deferred through the effective use of the appropriate investment vehicles and strategies. Let us review why adopting techniques to avoid, manage, or defer taxes should be an important part of the investment choices we are making. The Current U.S. Tax Situation The financial crisis of 008 ushered in a period when federal income taxes began to increase in order to address the national debt in the U.S., a trend that we anticipate will continue. The expiration of the so-called Bush tax cuts at the end of 0 resulted in higher taxes for millions of taxpayers, and could very well mark the beginning of a long-term structural increase in taxes. While the 04 fiscal year-end deficit did register its lowest percentage increase (relative to the U.S. Gross Domestic Product) since before the recession, according to the U.S. Treasury, the deficit remains at $ billion annually. Higher taxes have helped to address the deficit over the last several years, but in its 04 long-term budget outlook, the non-partisan Congressional Budget Office warned that spending on entitlements such as major health care programs and Social Security are unsustainable. Given the rift between Republicans and Democrats regarding the budget and spending, a compromise on significant entitlement reform seems unlikely. So, how can policymakers prevent the deficit from becoming dangerously high relative to the U.S. Gross Domestic Product (GDP)? By increasing revenue or, put more bluntly, by raising taxes. The Government Search for Revenue Will Likely Continue We all know that the demands on government spending are increasing. Our aging population will place a greater burden on Social Security, Medicare and Medicaid. Decaying infrastructure will require the repair or rebuilding of roads, bridges and mass transit systems. Federal and state debt levels are continuing to rise, with the federal debt over $8 trillion and counting. The reaction at all levels of government is to close tax loopholes and look for more revenue opportunities. Gross Domestic Product (GDP) definition: The monetary value of all the finished goods and services produced within a country's borders in a specific time period, usually calculated on an annual basis. Source: U.S. Department of the Treasury as of February 8, 05. MI PAGE

2 Taxes Are High and Your Tax Burden Has Increased Federal Tax Rate Increases from 0 to 03 Compensation or Wage Income (39.6% tax +.45% Medicare Tax + 0.9% health care reform surtax) 4.95% Qualified Dividends (0% tax + 3.8% health care reform surtax) Long-Term Capital Gains (0% tax + 3.8% health care reform surtax) 5% 5% 3.8% 3.8% Taxable Bond Interest (39.6% tax + 3.8% health care reform surtax) Nonqualifying Dividends (39.6% tax + 3.8% health care reform surtax) Short-Term Capital Gains (39.6% tax + 3.8% health care reform surtax) 43.4% 43.4% 43.4% 0% Source: Tax Policy Center 0 Rate 03 Rate This chart is for illustrative purposes only and shows the highest current tax rates plus the new 3.8% Medicare surtax, where applicable. The Impact on Individual Investors Many investors focus most of their investment attention on asset allocation and the selection of appropriate investment strategies to seek to achieve their risk/reward goals. In the decision-making process, a less common consideration is the impact of taxes. And, even less common is the disciplined selection of investment strategies that allow goals to be realized in a tax-efficient manner. In sum, investors often fail to consider that: It s not what you make, it s what you keep. Taxes can take a significant bite out of investment returns. Over the past five- and ten-year periods, for example, the average large-cap equity fund manager has lost 70 and 76 basis points of return to taxes, respectively, on an annualized basis. That represents a significant reduction between before- and after-tax returns for the typical large-cap fund investor, particularly when compounded over time. Capital Gains Taxes Can Significantly Reduce Earnings If the current bull market in equities continues, the average yearly return attributable to capital gains is likely to increase at a disproportionate level as well. In 04, for example, capital gains distributions for large-cap funds averaged 8.% of investors total return. This is up significantly from just 0.% just four years earlier. For a hypothetical investor with a $00,000 investment and a 0% capital gains tax rate, that means that an 8.% capital gains distribution would cost the investor $,640 in taxes, reducing total return by over 50 basis points. Source: Morningstar Direct, AMG Funds, includes funds with at least a 5-year track record, using data through June 04 using Morningstar s Tax Cost Ratio definition. Source: Morningstar Direct, AMG Funds, includes funds with at least a 5-year track record. Past performance is no guarantee of future results. PAGE

3 Even if equity markets retreat, as some anticipate, investors not actively seeking to minimize capital gains distributions are likely to continue to pay taxes on embedded gains. This was the case in 008, when the average large-cap fund had a capital gain of 0 basis points and the tax bill to go with it despite an average total return of -38.%., The Portion of Annual Return Attributed to Capital Gain Distributions for Morningstar Large-Cap Funds 3 Gains Captial Gain Return % Percentage of Realized Capital of Annual Returns Source: Morningstar Direct, AMG Funds Capital gain return is the portion of the holding period return that is attributed to realized capital gain distributions. Unrealized gains are still embedded in the NAV and have not been distributed to shareholders yet. This calculation assumes that the investor incurs no transaction fees, pays no taxes at the time of distribution, and reinvests all distributions paid during the period. 3 Funds with at least a 5-year track record. Data as of December 3, Strategies to Help Negate the Ever Bigger Bite of Taxes For investors looking to minimize the impact of taxes on their investment returns, there are three broad strategies they can follow. They can potentially avoid taxes by choosing investment vehicles not subject to certain taxation. Investors can also manage their tax situation by implementing investment strategies specifically designed to minimize the impact taxes have on returns. Finally, investors can defer taxes by investing in accounts not subject to immediate taxation. While these concepts are not necessarily mutually exclusive, it is helpful for investors to think about how they can utilize each or all of these strategies to minimize the burden taxes have on their investment returns. Avoiding Taxes With Municipal Bonds Investors in some fixed income instruments, such as municipal bonds, have the ability to avoid most taxes. Interest payments on municipal bonds are exempt from federal taxes and may be exempt from state and local taxes depending on the state and local tax laws that apply where you file your income tax return. 3 Municipal bonds are debt securities issued by a state, municipality, county or special purpose district such as public schools or airports. Bonds may be general obligation bonds or issued in order to finance capital expenditures. It is important to point out that, in a rising tax environment, munis may also offer compelling taxable equivalent yields relative to U.S. Treasuries. In the chart below, consider the current municipal yield advantage, relative to Treasuries, across the maturity spectrum. Funds with at least a 5-year track record. Source: Morningstar Direct, AMG Funds. 3 Investment income from municipal bonds may be subject to certain state and local taxes, and, depending on your tax status, the federal alternative minimum tax. Capital gains are not exempt from federal income tax. PAGE 3

4 Municipal Bonds Offer Compelling Taxable Equivalent Yields Municipal Bonds Remain Attractive Relative to U.S. Treasuries 5.5% 5.05% Taxable Equivalent Municipal Yields % Yield 4.5% 3.5%.5%.33% 3.60% Municipal Yield Advantage.5% 0.5% 0.85% Treasury Yield Year 5 Year 0 Year 30 Year Year 5 Year 0 Year 30 Year Taxable Equivalent Municipal Yield 0.85%.33% 3.60% 5.05% Treasury Yield 0.67%.65%.7%.75% Municipal Yield Advantage +0.8% +0.68% +.43% +.30% Assumes: 39.6% Federal Tax Rate + 3.8% Affordable Care Act surtax. Source: Municipal Market Data and Bloomberg As of December 3, 04 Managing Taxes Within an Equity Portfolio Ultimately, investors should focus on what you bring home after taxes. Most equity mutual fund portfolio managers focus exclusively on generating alpha, or incremental returns, relative to their benchmark, net-of-fees, without considering the tax impact of their investment decisions. For example, after a six-year bull market, the top 0 large-cap equity funds are all currently holding significant unrealized capital gains (see table on next page). In the event of a market correction, this could result in high realized capital gains, which could generate a big tax bill for their investors. PAGE 4

5 Unrealized Capital Gain Exposure Fund Unrealized Capital Gain Net Assets (Share Class) Unrealized Cap Gain (Potential cap gain exposure as a % of current Share Class Net Assets) Fund $34,693,48,05 $7,966,098, % Fund $9,798,550,430 $0,3,744, % Fund 3 $5,43,038,570 $85,60,984, % Fund 4 $,79,36,77 $96,674,385, % Fund 5 $3,988,0,830 $76,09,66, % Fund 6 $30,7,007,94 $7,467,57, % Fund 7 $0,58,558,864 $57,833,874, % Fund 8 $6,834,39,50 $60,60,, % Fund 9 $8,98,74,687 $5,839,34, % Fund 0 $4,95,605,59 $43,36,689, % Fund $7,00,698,880 $38,58,643,7 4.38% Fund $,385,35,30 $8,039,908, % Fund 3 $7,903,49,58 $8,54,6,54 8.3% Fund 4 $9,838,074,370 $4,05,67, % Fund 5 $7,674,49,974 $4,7,45,30 3.% Fund 6 $7,884,700,000 $4,367,337, % Fund 7 $9,83,605,388 $3,75,679, % Fund 8 $6,988,7,85 $,549,560, % Fund 9 $4,538,73,000 $3,436,445, % Fund 0 $8,56,454,497 $,799,50, % Funds with at least a 5-year track record. Data reported is share class level data. Includes Blend, Value and Growth Funds. Assets under management as of December 3, 04. Source: Morningstar Direct, AMG Funds Data as of December 3, 04. Techniques to Manage Taxes Within an Equity Portfolio Portfolio managers of equity mutual funds that focus on after-tax returns use a range of techniques to limit the difference between before- and aftertax returns. These include, but are not limited to: Delaying the realization of gains until they move from short-term to long-term to take advantage of lower long-term capital gains tax rates Harvesting capital losses to offset realized gains Trading with tax-lots in mind (selling the shares of a security with the highest cost basis first to help reduce the level of realized capital gains) Avoiding wash sales the sale of a security that occurs when a stock is sold at a loss and is bought again within 30 days. If a trade is deemed a wash sale, it prevents a portfolio manager from using the capital loss generated by a sale to offset a capital gain within a portfolio Tax-managed strategies can take advantage of these techniques by focusing on the after-tax impact a trade will have on the overall portfolio. PAGE 5

6 Deferring Taxes Investors can postpone taxes on investments through the use of tax-deferred vehicles such as individual retirement accounts (IRAs), employersponsored retirement savings plans, or state-sponsored 59 college savings plans. Investments in tax-deferred accounts allow individuals to defer the payment of taxes on investment gains until the future and reduce the size of their current tax obligation. The primary vehicles for tax-deferred investment growth are traditional IRA, Roth IRA and 40(k) accounts. There are many benefits to these vehicles for investors looking to save for retirement, including for some employees in 40(k) plans a level of matching company contributions. The benefit of these retirement savings vehicles is the ability the investment portfolio has to grow and potentially compound in value without the immediate burden of tax payments. Investment strategies that are less tax-sensitive with regard to their investment process are potentially more appropriate, therefore, within these types of accounts. Maximizing tax-deferred contributions can help reduce your taxes now so you have more savings at hand when you retire later. 05 Contribution Limits Regular Contributions Catch-Up Contributions (age 50 or older) IRA or Roth IRA $5,500 $,000 40(k) $8,000 $6,000 Roths vs. Traditional Retirement Vehicles With the Roth version of 40(k) and IRA accounts, investors contribute money after paying taxes. Roth contributions do not reduce taxable income right now, but they allow the savings to grow tax-free; and after age 59/, withdrawals can be made tax-free. Roth IRAs are not subject to rules requiring minimum annual distributions after age 70/ during the investor s lifetime and also allow the tax benefits to pass on to heirs. Traditional IRAs have two potential tax benefits. The first is deductibility, which can reduce the current tax burden. The second is tax-deferral, which can help increase gains due to the power of compound earnings. By deferring taxes until later in life, investors may also pay taxes at a lower rate when they do withdraw from their retirement accounts in most cases, they will have stopped working, so the effective tax rate may be lower. All withdrawals from traditional IRAs are typically taxed at the investor s current tax rate. Keep in mind that Roth 40(k) contributions are not transferrable once money is invested into a Roth 40(k) account, it cannot be moved to a regular 40(k) account or other retirement savings vehicles. However, conversions from a Traditional IRA to a Roth RIA can be reversed within a certain timeframe, which the IRS defines as recharacterizing the account. Conclusion As we have shown, Ben Franklin was only partly right: death may be a certainty, but the certainty of taxes and their sting can be minimized through avoid, manage, and defer strategies. You can avoid taxes by choosing investment vehicles not subject to certain taxes. You can manage your tax situation by implementing strategies specifically designed to minimize the impact taxes have on returns. And finally, you can defer taxes by investing in accounts not subject to current taxes. Since they are not mutually exclusive, how you choose to utilize some or all of these strategies will determine how successful you can be in minimizing your own tax burden. PAGE 6

7 Why choose AMG Funds? AMG Funds provides access to premier boutique asset managers through a unique partnership where our fund advisors are truly independent. We are not beholden to a single investment approach or a single manager to help find the best investment solutions. Our innovative approach leverages our independent advisors expertise to deliver products that cover the complete asset class spectrum. Combine this with the most efficient delivery of investment expertise in the asset management business and you have unmatched resources to meet your wealth management needs. Next Steps Contact your advisor to determine how you can take advantage of these avoid, manage and defer strategies. For more information on our Tax Impact Series, visit DISCLOSURES Investors should carefully consider the Fund s investment objectives, risks, charges and expenses before investing. For this and other information, please call or visit for a free prospectus. Read it carefully before investing or sending money. The tax information contained herein is provided for informational purposes only. AMG Funds does not provide legal or tax advice. Always consult an attorney or tax professional regarding your specific financial or tax situation. Although tax-managed mutual funds are managed to minimize taxable distributions, they may not be able to avoid taxable distributions. Investing involves risk, including possible loss of principal. Investments in debt securities are subject to risks such as default risk and fluctuations in the perception of the debtor s ability to pay its creditors. Changing interest rates may adversely affect the value of an investment. An increase in interest rates typically causes the value of bonds and other fixed income securities to fall. Issuer of bonds may not be able to meet interest or principal payments when bonds come due. Factors unique to the municipal bond market may negatively affect the value in municipal bonds. Funds are distributed by AMG Distributors, Inc., a member of FINRA, SIPC. AMG Funds LLC is a subsidiary and U.S Distribution arm of Affiliated Managers Group, Inc. (NYSE: AMG). Each of us at AMG Funds appreciates the continued opportunity to assist you with your investing needs. If you have any questions, please call AMG Funds LLC. All Rights Reserved. PAGE 7

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