SEPTEMBER 11, 2012

Taxes and investing

Frank Pape, Director of Consulting

Important Information

p.2

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets.

Income from funds managed for tax efficiency may be subject to an alternative minimum tax, and/or any applicable state and local taxes.

Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Past performance is not indicative of future results.

Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments. and is a subsidiary of The Northwestern Mutual Life Insurance Company.

Copyright© Russell Investments 2012. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investment Group. It is delivered on an “as is” basis without warranty.

Russell Financial Services, Inc., member FINRA, part of Russell Investments.

First Used: September 2012

RFS-9055

The only difference between a

taxman and a taxidermist

is the taxidermist leaves the skin.

~ Mark Twain

p.3

Three take-aways

Taxes and taxable assets: why it matters 1

2

3

Rates likely going in one of two directions

(guess which way?)

Taxes can be managed

p.4

Inflection point?

2013

p.5

Taxes…A step through (modern) history

November 6,

2012

p.6

Why do you care? A percentage to remember

p.7

50%

Where have Federal tax rates been?

Source: TaxPolicyCenter.org. As of June 30, 2012.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

19

16

19

19

19

22

19

25

19

28

19

31

19

34

19

37

19

40

19

43

19

46

19

49

19

52

19

55

19

58

19

61

19

64

19

67

19

70

19

73

19

76

19

79

19

82

19

85

19

88

19

91

19

94

19

97

20

00

20

03

20

06

20

09

Income

Corporate

Capital Gains

Top marginal rate

35%

35%

15%

20

10

p.8

Tax Rates Spin the Wheel

p.9

Who pays what?

2010: Joint Committee on Taxation

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0% 10% 15% 25% 28% 33% 35%

Nu

mb

er

of

Ta

xp

aye

rs (

00

0’s

)

Marginal Rate

16%

35% of taxpayers

30%

15%

3% 1%

0.5%

869,000 returns

81% of taxpayers paid a marginal rate of 15% or less

p.10

What do taxpayers think they pay?

5%

26% 25%

10%

2% 1%

31%

Less Than 10%

10% - 20% 20% - 30% 30% - 40% 40% - 50% More than 50% Don't Know

Source: CBS/New York Times poll (April 2010)

On average, about what % of their household income

would you guess most Americans pay each year?

p.11

Source: Office of Management and Budget. As of June 30, 2012.

17.8% = 1950 – 2011

Average Revenue

19.9% = 1950 – 2011

Average Receipts

10%

12%

14%

16%

18%

20%

22%

24%

26%

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

% o

f G

DP

Receipts Outlays

2009:

25.2%

2009:

15.1%

p.12

Imbalance between government we want and government we pay for

$0.4 $0.9

$3.2

$5.7

$7.9 $8.5 $9.0 $10.0

$11.9

$13.6

$19.6

$0

$2

$4

$6

$8

$10

$12

$14

$16

$18

$20

1970 1980 1990 2000 2005 2006 2007 2008 2009 2010 2015

U.S

. D

eb

t ($

Tri

llio

ns)

PR

OJ

EC

TE

D

p.13

Why is this important? Increasing at an increasing rate

13

Source: U.S. Treasury

Source for projected data: U.S. Treasury and Reuters. As of November 30, 2011.

Growth of national debt

One Trillion (one million, millions)

What's a TRILLION dollars among friends

One Billion (one thousand, millions) One Million

14 p.14

Defense and Int'l. Security

Assitance, 20%

Safety Net Programs, 13%

Interest on Debt, 6%

Medicare/Medicaid/CHIP, 21%

Social Security, 20%

Benefits for Fed. Retirees and Veterans, 7%

Transp. and Infrastructure, 3%

Education, 2% Science and Medical Research,

2% All

Other, 6%

Defense 20%

Medicare/Medicaid 21%

Social Security 20%

Interest 6%

67%

Source: www.cbpp.org/cms/index.cfm?fa=view&id=1258. As of August 13, 2012.

p.15

How do you spend $3.6 Trillion? 2011 federal expenditures

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Itemized and Above the line deductions

Cap gains treatment, retirement income, etc.

Child tax credit, Earned income tax credit, SS exclusion

Other preferences

2015 Projected

tax expenditures

Mortgage Interest,

15%

Charitable contributions,

8%

State & Local Taxes, 21%

Employer provided

health insurance, 44%

Other, 12%

Components of Itemized and above the line deductions

To keep tax revenue neutral,

you need to cut tax expenditures

by 72%. What do you pick?

Tax Policy Center: How hard is it to cut tax preferences to pay for lower tax rates? July 10, 2012

p.16

What if you lowered the top marginal rates to 28%, kept capital gains at 15% and repealed the AMT?

What have investors done in prior periods of changing tax rates?

p.17

› Due to tax reform in 1986, the top marginal rate decreased in 1987

from 50% to 28%.

› Aggregate realizations doubled from 1986 to 1987

› Top cap gains rate decreased in 1987 from 50% to 28%.

› Realizations doubled from 1986 to 1987

› Top cap gains rate went from 29% to 21% in 1997

› Realizations rose 3.3% of GDP to 6.5% in 2000 (helped by tech run)

› Changing the rate undoubtedly impacts investor behavior

› Is the change perceived to be temporary or permanent?

› Treatment will be key topic in 2013

Fiscal Cliff in 2013

p.18

Politicians of both parties will be motivated to

prevent either (or both) in the face of weak economic data

› Taxes:

› Expiration of Bush era tax rates, payroll tax cut

› 3.8% increase on unearned income for some taxpayers to help

finance health care reform

› Spending:

$1.2 trillion of spending cuts over 10 years resulting from

the Budget Control Act of 2011

› Combination of increasing taxes and reduced spending

creates a “fiscal cliff” the economy must overcome in 2013

Rates – absent government action

› Absent government action, planned expiration of Bush era

tax rates at the end of 2012

› Absent government action, a 3.8% increase on unearned

income to help pay health care reform beginning 2013

Maximum Federal tax rates Current 2013

Long term gains 15.0% 20.0%

Short term gains 35.0% 39.6%

Qualified dividends 15.0% 39.6%

As of August 2011.

p.19

Today’s backdrop

› Simpson-Bowles Commission on Fiscal Responsibility

(December 2010)

› Budget Control Act of 2011

› Bipartisan committee (12 members) to initially cut

$1.2 trillion announced in November 2011

› Fiscal Cliff

› 2012 Elections

› Republican plan, Democratic plan, Grand Bargain, Gang of Six, etc.

› Americans for Tax Reform’s Taxpayer Protection Pledge

(no new taxes)

› Signatories include 236 House members / 41 Senators

As of December 31, 2011.

p.20

Lots of debate about the deficit, but when it’s all said and done, likely to be…

› Reduced or modified services

› Higher retirement ages

› Expanded means testing for social services

(Medicare/Social Security)

› And...higher taxes (it’s already happening)

p.21

› Fund A is 80% tax-efficient (8%/10%)

› Fund B is 67% tax-efficient

› Which Fund do you choose?

Fund A is “more tax-efficient”

Tax efficiency: % of return retained after taxes

It’s the money in your pocket!

10%

8%

15%

10%

Pre-tax return After-tax return

A A B B

This hypothetical example is for illustration only and is not intended to reflect the return of any actual investment. Investments do

not typically grow at an even rate of return and may experience negative growth

p.22

Tax-efficiency A primer

Evaluating tax efficient investments

› Current tax analysis impacted by 2008/early 2009

market downturn.

› 2009 short term gains declined 51% from 2008 and

long term gains declined 96%1.

› Make sure comparing like returns (pre-tax, pre-

liquidation, post-liquidation, AMT free, assumed tax

rate, etc).

It’s the perfect storm: Tax rates likely increasing and

mutual funds are using up capital losses incurred during 2008.

(1) Lipper Research: Taxes in the Mutual Fund Industry - April 2010

p.23

Taxable distributions Do you see a pattern?

Large Cap Equity Average: Morningstar Large Cap Equity Blend Universe – funds with assets > $1billion as of 12/31/2011

$ of Share Morningstar's Large Cap Equity Blend Universe - funds with assets > $1billion as of 12/31/2011

U.S. Large cap equity

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

$2.27

$/S

ha

re

Dis

trib

ute

d

-11.50% -21.50%

31.10%

12.00% 6.10%

15.70% 5.10%

-37.40%

28.30%

16.90%

1.03%

Ru

ss

ell

30

00

®

Ind

ex

Re

turn

p.24

Assessing tax efficiency

Tax-oriented

Tax-active

Tax-aware

Inherently efficient

Tax-oblivious

Actively harvest losses throughout year—

focused on active after tax returns

Tax aware but also looks to harvest

losses

Conscious of a stock’s long-term

gains vs. short-term gain status

Generally lower turnover; buy and

hold approaches

No concern about taxes

Tax Efficiency

p.25

› Evolution of tax-

managed investing

› What’s changed?

Not Changed?

› What’s on the horizon?

Tax aware investing Not yesterday’s approach

p.26

How can investment products strive for tax-efficiency?

› More concentrated portfolios

› Longer holding period

› More growth oriented securities

› Be active in regards to opportunistic capital loss

harvesting

p.27

Summary

› Taxable assets represent large pool of dollars

› Imbalance between government spending and

government revenues

› Taxes can be managed

p.28

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