It s Your Money Why Give Away More Than You Have To?

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1 It s Your Money Why Give Away More Than You Have To? by David Zierath, SEI Private Wealth Management As we enter yet another tax season, it might be constructive to remind investors of some of the methods available to help take some of the bite out of one s tax liability. As always, readers should be reminded that the underlying premise around investing is that it s not what you make that holds relevance, but what you keep in the end that counts. To that end, this paper touches on a few of the trends facing taxable investors as well as on some of the alternatives available to help reduce the impact of taxes. Key Points Tax rates are likely to migrate upwards to help alleviate current and future fiscal deficits The effect of taxes on one s portfolio can be especially harmful over time There are a variety of methods available that investors need to consider in order to increase their aftertax returns Many of these methods can be used together in a layered approach further enhancing the tax efficiency of one s portfolio

2 Current Tax Environment Given the public outrage over recent discussions to repeal the Bush era tax cuts, one might believe that prevailing tax rates sit at abnormally high levels. However, if looked at on a historical basis, income and capital gains tax rates in the U.S. remain at or near their lowest levels. 1 As of March 211, the highest ordinary income tax rate lay at 35% while long-term capital gains resided at 15%. 1 CHART 1 Highest Bracket Tax Rate (percent) Highest Bracket Tax Rate - Income Highest Bracket Tax Rate - Income Maximum Tax Rate - Long-Term Gains Maximum Tax Rate - Long-Term Gains Source: Internal Revenue Service and Tax Foundation At the same time, the 28 financial crisis has left the United States with a significantly deeper budget deficit. 2 Even if adjusted for GDP levels (deficit per GDP), the deficit remains at post WWII depths. 3 Moreover, this measure is a current snapshot ; it does not address a future of ballooning Medicare and Social Security obligations. Given this, it seems quite probable that an environment combining a deep fiscal budget deficit with a historically low tax rate will necessitate a future with higher taxes. CHART 2 Surplus or Deficit (-) Source: Office of Management and Budget Estimate Estimate 21 Estimate 215 Estimate 1 Internal Revenue Service. U.S. Individual Income Tax: Personal Exemptions and Lowest and Highest Bracket Tax Rates and Tax Base for Regular Tax; Tax Foundation: Federal Capital Gains Tax Collections 2 Office of Management and Budget: Summary of Receipts, Outlays, and Surpluses or Deficits (-) in Current Dollars, Constant (FY 25) Dollars: Office of Management and Budget: Summary of Receipts, Outlays, and Surpluses or Deficits (-) as Percentages of GDP: SEI Private Wealth Management 1 Freedom Valley Drive Oaks, Pa

3 Investors Dilemma -1 If investors taxes rise, it s important to examine the -125 potential implications that may have on portfolios and -15 portfolio returns. As Chart 3 demonstrates, taxes can have a debilitating impact on a portfolio s returns. The blow may not be noticeable year to year, but the cumulative effect may very well mean the difference between retirement in relative comfort versus the necessity of continued work (with a clear distinction being working because you have to rather than because you enjoy it.) In the scenario below, you ll see that a hypothetical investment in a diversified portfolio allocation over thirty years could lose nearly 5% of the potential value to taxes Estimate 215 Estimate CHART 3 Taxes Reduce Performance Over TimeGrowth of $1,* $3,5, $3,, $2,5, $2,, $1,5, 52% Lost totaxes Before -Tax Portfolio: $2,654,22 $1,, $5, After -Tax Portfolio: $1,284, Source: SEI and Parametric Portfolio Associates Parametric Portfolio Associates: 6% Russell 3; 4% Barclays Capital Aggregate; No Liquidation. The Russell 3 and Lehman Aggregate are unmanaged indices and are not available for individual investment. Interest income and dividends are taxed annually at historical top marginal tax rates; capital gains are realized at 5% per year and are taxed at the historical long-term capital gains tax rate. Past performance is no guarantee of future results. Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. *A hypothetical tax-free $1, portfolio (invested 6% in stocks and 4% in bonds) held for 29 years would have grown to about $2.2 million. If the portfolio was taxed like an average mutual fund, it would have lost 5% of its value, due to taxes paid and earnings lost on that money, Tax-managed investment strategies are designed to minimize capital gains distributions and maximize after-tax returns. SEI Private Wealth Management 1 Freedom Valley Drive Oaks, Pa

4 Possible Solutions In a future where we ll likely see rising tax payments, it will become even more important for investors to employ every technique available to help them reduce the potentially devastating effects these payments will have on their portfolios. To this end, there are a number of tools currently at their disposal: Tax Sensitive Strategic Models Overlay Portfolio Management Tax Managed Investments Tax Sensitive Strategic Models: The first generation of tax sensitive models was fairly simplistic. Investors typically replaced dollar-for-dollar their taxable fixed income with municipal bonds. The risk, return, and correlations of tax-exempt positions can be significantly different from their taxable counterparts; which will in turn alter the proper strategic allocation mix. For example, tax sensitive models may not necessarily require alternative investments to achieve risk/return targets whereas non tax managed models may. In effect, the presence or absence of taxes can dictate the percentage asset required, or in this instance whether the asset class (alternatives) is required at all. Additionally, first generation models simply placed highly taxed investments into retirement based or tax deferred vehicles (IRA s, 41k s, SEP s, ESOP s, etc.) Today, modern model construction does employ these techniques, but has advanced even further making the relative placement of taxable assets more efficient. Overlay Portfolio Management: An overlay manager essentially oversees the execution of purchases and sales across a multi-manager account structure. In this capacity, the overlay can defer shortterm gains until long-term, coordinate through wash sale rules, and actively harvest tax losses. A 23 study addressing the effectiveness of overlay portfolio management suggested that overlay managers are able to add.3% to.6% or more in after-tax return on an annualized basis. 4 In fact, more recent empirical evidence from an overlay manager demonstrated that the after-tax benefit was on the order of 1.37% annualized. 5 Moreover, an effective overlay manager does not accomplish this generically across all their managed assets; rather effective overlay management is applied specifically to each individual investor and his or her unique portfolio. The objective is truly customized tax management. As a result, a tax sensitive strategic asset allocation model can be constructed so that all asset classes work in conjunction, within the proper taxable or tax-deferred vehicle to help achieve an expected return, mitigate risk and do so in a tax efficient manner. 4 The Journal of Wealth Management, Spring 23. Overlay Portfolio Management in a Multi-Manager Account. 5 Parametric Portfolio Associates, Spring 29. The Value of Overlay Portfolio Management within a UMA. SEI Private Wealth Management 1 Freedom Valley Drive Oaks, Pa

5 Tax Managed Investments: Today, investors can choose from a spectrum of tax advantaged vehicles consisting of a broader range of asset classes. AAA rated municipal bonds are no longer the sole investment designed to minimize one s tax impact. Although investment grade municipal bonds are still a core component of one s portfolio, tax advantaged income funds may augment yield by combining high yield tax-exempt bonds in conjunction with preferred stocks (whose dividends currently receive lower, qualified tax rates versus income). On the equity front, specialized managers may focus in low turnover strategies to help mitigate tax consequences. Further, some managers by design proactively harvest losses within their stock positions while they manage to an index. In effect, the gross return looks much like an index return, however garnering losses helps to offset not only the manager s gains but may be used to offset unrelated gains elsewhere across investment portfolios. Any one of these (or other) methods may be effective independently, but if employed as a troika they can help to noticeably reduce an investor s tax consequence. Summary Given the current and future levels of government obligations, it should not be unexpected to see rising taxes for investors. These very same taxes reduce portfolio performance and act as a drain on returns. In fact, they can be one of the largest detractors of wealth accumulation and on the subsequent ability for someone to achieve their financial and personal life goals. It seems then, that there is considerable merit in managing what you can. That would entail utilizing effective tax management techniques independently or in conjunction; as a result you can enjoy the benefits of your investments working for you. SEI Private Wealth Management is an umbrella name for various life and wealth services provided through SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. There are risks involved with investing including possible loss of principal. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only. Neither SEI nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein: and (iii) you should seek advice based on your particular circumstances from an independent tax advisor. There are risks involved with investing, including loss of principal. SEI Private Wealth Management 1 Freedom Valley Drive Oaks, Pa SEI (1/11)