Tax Readiness Perspective Tax Strategy in a Time of Change A new administration may bring tax changes, but having a sound tax strategy in place still makes sense Tax Season 2017 Executive Summary This year s changing tax environment could be favorable for some investors. The new administration has made reform proposals aimed at cutting taxes for the middle class. These reforms could also result in a significant tax windfall to the wealthiest earners. Most reforms would need the approval of Congress, however, and are therefore subject to change. Given the uncertainty of the current situation, the pursuit of a sound tax management strategy should remain a priority for investors. Tax management continues to be an essential part of maximizing your investment portfolio s after-tax returns. Strategies to consider for the months ahead include: XXReducing your tax burden with municipal bonds XXPlacing high-tax investments in tax-advantaged accounts, and low-tax investments in taxable accounts XXIncreasing your tax-deferred earnings through 401(k)s, IRAs, 529 Plans and HSAs XXUsing tax diversification strategies for flexible draw-down options in retirement With a well-thought-out strategy in place, you will be prepared for whatever tax changes the future may hold.
Tax Changes Are in the Forecast Here s What You Need to Know With the new administration, the U.S. is potentially on the cusp of a drastically different tax environment. Without giving much detail, President Trump has promised reforms designed to lower taxes for the middle class. According to the Tax Policy Center, the tax breaks could also be especially significant for the wealthy, who would benefit not only from a lower income tax bracket, but also from reduced taxes on investment income and the elimination of estate taxes. Although there s no guarantee that the President s proposals will be implemented, Republican control of the House and Senate makes that prospect more likely. In the paragraphs below, we ll give a high-level view of certain of the president s proposals that could potentially affect investors. It should be noted that the House has also released its own blueprint for tax reform, the details of which are not discussed here. Although there are similarities between the House s proposals and those of the President, they are by no means identical. The Big Picture: A Potential Tax Benefit for Wealthy Investors A key element of the president s potential tax plan includes compressing the country s current seven federal income tax brackets to three. As the table below shows, wealthy taxpayers would benefit from a significant portion of the total tax cut if this proposal were to go through. TAX BRACKETS Taxpaying Group Total population of taxpayers Household Breakdown Average Tax Cut Share of Total Tax Cut About 140 million $2,940 100% Top 20% of households Households with incomes of more than $143,100 $16,600 Nearly 80% Top 1% of households Households with incomes of more than $699,000 $215,000 Nearly 50% TAX BRACKETS Top 0.1% of households Households with incomes of more than $3.7 million $1,100,000 Nearly 25% Source: James R. Nunns, Len Burman, Ben Page, Jeff Rohaly, Joe Rosenberg. An Analysis of Donald Trump s Revised Tax Plan, Tax Policy Center, October 18, 2016, p.10. PAGE 2 TAX STRATEGY IN A TIME OF CHANGE
Federal Income Tax Brackets (2016) 2017 (Trump Proposal) Single Married, Filing Jointly Head of Household Married, Filing Jointly Income Brackets Marginal Rates Income Brackets Marginal Rates Income Brackets Marginal Rates Income Brackets* Marginal Rates $0 $9,275 10% $0 $18,550 10% $0 $13,250 10% <$75,000 12% $9,276 $37,650 15% $18,551 $75,300 15% $13,251 $50,400 15% $75,000 $225,000 25% $37,651 $91,150 25% $75,301 $151,900 25% $50,401 $130,150 25% >$225,000 33% $91,151 $190,150 28% $151,901 $231,450 28% $130,151 $210,800 28% Source: www.donaldjtrump.com $190,151 $413,350 33% $231,451 $413,350 33% $210,801 $413,350 33% $413,351 $415,050 35% $413,351 $466,950 35% $413,351 $441,000 35% * Brackets for single filers are half of the above-listed amounts. $415,051< 39.6% $466,951< 39.6% $441,001< 39.6% In addition to proposing a break on income taxes, the President has floated several other changes that could benefit wealthier investors. Potential Elimination of the Estate Tax President Trump s tax reforms call for the elimination of what it calls the death tax, which likely means the federal estate tax and the federal generation-skipping transfer tax. It is unclear whether President Trump s plan includes the elimination of the federal gift tax. Under current law, the federal estate tax rate is 40% and the federal estate tax exemption is $5.49 million per individual, which is indexed for inflation on an annual basis. Although the nature of the proposed changes remains quite unclear, it appears that the President s plan might repeal the federal estate tax, replacing it with a tax on capital gains in excess of $10 million on assets held until death. If these proposals were to become law, the investment strategies of wealthy investors would potentially change significantly: Charitable Giving Under current law, wealthy individuals who are subject to the federal estate tax have an incentive to make charitable bequests as a result of the unlimited charitable deduction. Elimination of the federal estate tax under President Trump s plan may remove or reduce incentives for such tax-driven charitable bequests. In addition, the President s campaign website proposed to disallow contributions of appreciated assets to private charities established by the decedent or their relatives. Though the president has not elaborated upon this statement, it appears to be a limitation on charitable giving, particularly in the context of private foundations. Capital Gains Under current law, assets held upon death receive a step-up in basis that eliminates tax on gain to the date-of-death value. Under the president s proposal, it appears that capital gains in excess of $10 million would be subject to the capital gains tax upon the decedent s death. With respect to the $10 million threshold, it is unclear under the President s plan whether this exemption amount applies to each individual or married couples. In either case, wealthy individuals will increasingly focus on income tax as opposed to estate tax considerations in their planning. Family Farms and Businesses If enacted, the President s proposal to eliminate the estate tax may make it easier to pass family farms and businesses down to children. However, as noted above, it is unclear how the capital gains tax will affect the transfer of such business interests. TAX STRATEGY IN A TIME OF CHANGE PAGE 3
A Potential Break on the Net Investment Income Surtax To help fund the Affordable Care Act, Congress enacted a 3.8% surtax on net investment income from dividends, interest and capital gains. Under Trump s new plan, the Net Investment Income Tax, which applies only to certain highincome taxpayers, would be eliminated (along with the Affordable Care Act). Lower Taxes? Perhaps. But Having a Tax Strategy for Your Portfolio Is Still Essential Some of the proposed tax benefits would be offset by the elimination of personal exemptions, as well as a cap of $200,000 for married joint filers ($100,000 for single filers) on itemized deductions such as mortgage interest and charitable donations. Each of these changes will need to be negotiated with Congress and they are therefore far from certain. As to the timing, tax proposals that are enacted could be applied retroactively as of January 1, 2017, or could take effect at some later date. All this uncertainty makes planning around the new administration s tax reform tricky. Regardless of which policies are enacted and what the timing might be, it s wise to make the strategic tax management of your portfolio a priority. No financial plan is complete without careful consideration of taxes. Although other factors like diversification, risk tolerance and planning for short- and long-term financial goals should be the primary drivers of your investment decisions, it s important to remember to have a proactive tax management strategy in place as well. KEYS TO SOUND FINANCIAL PLANNING INDIVIDUAL CIRCUMSTANCES TIME HORIZONS SHORT & LONG TERM GOALS RISK TOLERANCE TAX MANAGEMENT STRATEGY Diversification does not guarantee a profit or protect against a loss in declining markets. ASSET ALLOCATION & DIVERSIFICATION PAGE 4 TAX STRATEGY IN A TIME OF CHANGE
Lower Your Taxes with Municipal Bonds Municipal bonds have long been a mainstay of higher-net-worth investors portfolios because interest income on these bonds is generally exempt from federal taxes, and potentially state taxes as well.1 The way to evaluate a municipal bond investment is therefore by its tax-adjusted yield, which allows for an apples-to-apples comparison with taxable bonds that have similar characteristics. As the table below shows, on a tax-adjusted basis, municipal bonds have in the past provided a better return than taxable bonds with higher before-tax yields. If Trump s tax reforms were to go through, this advantage would be diminished, since the taxes on income from corporate and other taxable bonds would be less. That said, it still pays to consider municipal bonds as an effective option for lowering your taxes. Municipal Bond Tax Equivalent Yields Municipal bonds frequently offer an after-tax yield advantage over comparable taxable U.S. Treasury bonds. 5.37% 6 5 4.08% 4 Municipal Yields 2.14% 3.16% 3 % Yield Municipal Yield Advantage 2 After-tax Treasury Yield 1 2 Year 5 Year 10 Year 30 Year 0 2 Year 5 Year 10 Year 30 Year Municipal Yields 2.14% 3.16% 4.08% 5.37% After-tax Treasury Yield 1.19% 1.93% 2.45% 3.07% Municipal Yield Advantage 0.95% 1.23% 1.64% 2.31% Assumes: 39.6% federal income tax rate and 3.8% Medicare contribution tax Sources: Municipal Market Data and Bloomberg, as of December 31, 2016. Past performance is no guarantee of future results. 1 Depending on an investor s state of residence, 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. TAX STRATEGY IN A TIME OF CHANGE PAGE 5
Are Municipal Bonds Right for You? Municipal bonds are issued by states, government agencies and authorities, and come in two categories: 1. Revenue bonds are dependent on a specific revenue stream such as a toll highway. 2. General obligation bonds typically carry less risk since they draw on the full faith and credit of the taxing authority. That said, they may carry risk tied to the pension obligations of the state. As a general rule, investors in higher tax brackets who reside in states with high income tax rates (such as CA, IL, MA, NJ and NY) could stand to benefit more from investing in municipal bonds since they would be paying more in taxes on regular, taxable bonds. The decision about whether to invest in municipal bonds depends on several factors, including: Munis: Professional Management Matters By investing directly in municipal bonds, you assume the burden of assessing the creditworthiness of the issuer. Although defaults in the municipal sphere are rare, they do happen. For example, defaults in 2014 reached a record $9 billion, due in part to the bankruptcies of Detroit and Puerto Rico. 2 By investing in municipal bonds through a mutual fund, you benefit not only from the research capability of the fund manager, but also from lower trading costs associated with the larger scale of a fund. Lower costs can have a significant impact on returns over time. XXYour federal income tax bracket XXYour state-of-residence income tax rate XXThe current interest rate environment Lower costs Your financial advisor can help you determine whether municipal bonds are right for you. 2 Standard & Poor s 2015 Annual U.S. Public Finance Default Study And Rating Transitions PAGE 6 TAX STRATEGY IN A TIME OF CHANGE
Getting Tax-Smart with Mutual Funds There s a reason mutual funds are so popular: They re hard to beat for diversification, liquidity and professional management. But even in a more favorable tax environment, the mutual fund landscape may remain a dangerous place for investors who aren t armed with a tax management strategy. Taxable Distributions Put a Sizable Dent in Your Returns To qualify for special tax treatment under the Internal Revenue Code, mutual funds are required by law to distribute dividends and interest to investors at least once a year. Mutual funds may also make distributions of capital gains. These distributions can be substantial, and are generally taxable as ordinary income or as short- or long-term capital gains, respectively. When evaluating a mutual fund, most investors examine its performance track record, the stability of its management, its fees, and other factors that help determine whether it s a good fit for their goals. Once you ve selected mutual funds that meet your requirements, the table below can help you determine whether the fund would be better suited for your taxable accounts or your qualified, tax-advantaged accounts. Taxable Accounts Tax-Advantaged Accounts Best for tax-efficient investments, such as funds that: XXInvest in growth stocks with low or no dividends XXHold investments for more than one year to avoid short-term capital gains, which are taxed at a higher rate XXHarvest capital losses to offset realized gains XXTrade with tax lots in mind to avoid realizing unnecessary capital gains Best for investments that are likely to generate more taxable income, including funds that: XXInvest in securities paying higher levels of interest and dividends XXEngage in more buying and selling of securities, leading to a higher turnover rate XXFocus on funds pre-tax performance at the expense of tax management XXAvoid wash sales, which negate the benefit of taking a capital loss XXInvest exclusively in municipal bonds TAX STRATEGY IN A TIME OF CHANGE PAGE 7
Keep in mind that, unlike taxable accounts, IRAs and other taxadvantaged accounts don t offer the benefit of using capital losses to offset gains elsewhere in your portfolio. For Taxable Accounts, Remember to Buy Ex-Dividend As a shareholder, you pay the same taxes on fund distributions regardless of whether you ve been invested for a whole year or just one day. If you re thinking of buying shares in a mutual fund for a taxable account, it s usually wise to invest after the fund s ex-dividend date. That way, you buy your shares at a potentially lower price, since the share price typically falls by a percentage of the distribution paid. You also avoid paying taxes on the distribution. A Fund s Trading Activity Affects Your Taxes The size of a fund s distribution is linked to the amount of trading the portfolio manager conducts throughout the year. Funds with higher turnover ratios therefore tend to pay out larger taxable distributions. In addition, mutual fund managers are typically evaluated based on their fund s performance versus a benchmark, making them less concerned with tax efficiency. Consider placing high-turnover funds in tax-advantaged accounts. PAGE 8 TAX STRATEGY IN A TIME OF CHANGE
Strategies for Tax-Advantaged Accounts One of the most efficient ways to defer taxes on your investments is through tax-advantaged accounts like IRAs, 401(k)s, 529 college savings plans and health savings accounts (HSAs). Each of these accounts allows for income to grow tax-deferred. When compounded over time, that advantage adds up. The table below shows the growth of equal investments over time in one case, earnings are taxed, while in the other case, earnings grow tax-deferred. The Tax-Deferred Advantage (30-year growth of $50,000 in taxable vs. tax-deferred accounts) Earnings that grow tax-deferred may add up to a considerable advantage over time $250,000 $200,000 $150,000 $100,000 $50,000 Tax- Deferred Taxable $216,097 $130,518 $0 5 10 15 20 2 5 30 Years The above chart assumes a 5% annual rate of return and a combined federal and state tax rate of 35%. This is a hypothetical example shown for illustrative purposes only. It does not represent the performance of any actual investment product. Maximize Your 401(k) Many employers offer matching contributions for employees who invest in their 401(k) plans. If your employer has a matching program, this is one of the fastest ways to build tax-advantaged assets since you re essentially getting free money. Even if your employer doesn t offer a matching program, 401(k)s are a valuable way to increase your tax-deferred earnings growth. For these reasons, maximizing your company s 401(k) should be a top savings priority to consider. TAX STRATEGY IN A TIME OF CHANGE PAGE 9
IRAs: Roth or Traditional? Whether a traditional or Roth IRA makes sense for you depends on a number of things, including whether your tax bracket in retirement is higher or lower than your current tax bracket. Under the President s proposed plan, tax brackets would be heading lower for many investors, making the near future potentially a good time to pay taxes on retirement assets. If President Trump s plan leads to spiraling government deficits, however, taxes in the future may indeed head higher. With a traditional IRA, contributions may reduce your current taxable income and earnings grow tax deferred. When it s time to take withdrawals, you pay ordinary income taxes on distributions. If you expect to be in a lower tax bracket when you take withdrawals, the traditional IRA will generally be an advantage. Keep in mind that required minimum distributions (RMDs) from traditional IRAs begin at age 70 ½. Because they are taxed as income, RMDs could potentially bump you into a higher tax bracket. 2017 Contribution Limits Roth IRA Contribution Limit $5,500 Roth IRA Contribution Limit if 50 or over Traditional IRA Contribution Limit Traditional IRA Contribution Limit if 50 or over 2017 Income Limits Roth IRA Income Limits (for single filers) Roth IRA Income Limits (for married filers) $6,500 $5,500 $6,500 Phase-out starts at $118,000; ineligible at $133,000 Phase-out starts at $186,000; ineligible at $196,000 If, on the other hand, you find yourself in a higher tax bracket in retirement, you may have been better off investing in a Roth IRA, which would have allowed you to pay taxes at a lower rate when you originally invested. Roths have the added advantage of having no required minimum distributions, making them an attractive option for estate planning. However, Roth IRA contributions are only available to individuals under a certain income threshold. Investors above this limit can convert their traditional IRA or 401(k) to a Roth. In this case, you d pay income taxes now on the amount of the conversion. Add Flexibility in Retirement with Tax Diversification If you re unsure about whether your tax bracket will be higher or lower in retirement, it could make sense to have both a Roth and traditional IRA, as well as taxable savings in your plan. That way, when you reach retirement, you ll be able to choose a draw-down strategy that minimizes your taxes by using the right combination of tax-free, taxadvantaged and taxable accounts. As part of this strategy, your taxable savings become important as they can be accessed at any time without penalty (though you will need to pay capital gains tax). Having taxable assets to draw on in retirement can also help preserve your taxadvantaged accounts, giving you more years to benefit from tax-free compounded growth. Source: http://www.rothira.com/2017-roth-ira-limits-announced PAGE 10 TAX STRATEGY IN A TIME OF CHANGE
Being Ready for Change Your tax strategy is an important part of a larger financial planning process that includes an examination of your long- and short-term financial goals, an asset allocation and diversification strategy to manage volatility, and consideration of your investment time horizon and tolerance for risk. Decisions to reallocate for tax efficiency should not be taken lightly. Repositioning your portfolio all at once could involve transactions with tax consequences that offset any benefits. A better approach involves creating goals that will move you toward greater tax efficiency over time. As with any tax-related decisions, it s important to consider the advice of your tax advisor, who can help you determine the right course for your individual circumstances. Next Steps Contact your financial advisor and/or tax advisor to learn more about maximizing the tax efficiency of your portfolio. For more information, visit www.amgfunds.com/readiness. TAX STRATEGY IN A TIME OF CHANGE PAGE 11
About AMG Funds AMG Funds provides access to premier asset managers through a unique partnership where the investment managers are truly independent. AMG Funds is not beholden to a single investment approach or a single manager in delivering quality investment solutions. This innovative approach leverages each manager s specific expertise to deliver products that cover the complete asset class spectrum. Delivering the talents of all of these portfolio managers under a consolidated platform allows AMG Funds to offer unmatched access to specialized investment expertise. 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. An 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. 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). www.amgfunds.com linkedin.com/company/amg-funds 2016 AMG Funds LLC. All rights reserved. 033117 PER056