'Getting Real' about Returns: Fidelity® Viewpoint Explains Why Concept of 'Total Return' Requires a New Look with an Eye for Taxes and Inflation
New tax law changes resulting from the fiscal cliff deal are prompting questions from investors about the drag higher tax rates could have on portfolio returns in 2013 - and beyond. The Fidelity Investments® 2013 guide to taxes and Get real: focus on real after tax-returns Viewpoint both tackle that question, and help retirees understand why they may want to adopt a strategy focused on real after-tax returns (total return – taxes – inflation), and not just total return.
“Investors focused solely on what the market is doing for their portfolios are only seeing half the picture,” says John Sweeney, executive vice president at Fidelity. “It's the returns they can generate after inflation and taxes that tell the whole story. Fidelity is encouraging investors to sharpen their focus on real after-tax returns, which is what remains after taxes and inflation are accounted for, and not just on nominal pre-tax returns—also referred to as total returns.”
A recent Fidelity investor poll shows 63 percent of investors are concerned about taxesi. Taxes and inflation can both eat into the buying power of an investor's portfolio, which puts retirees living off their investments at particular risk. At worst, rising inflation and taxes may force retirees to increase withdrawals to maintain their lifestyle—which could mean they might run out of money prematurely in retirement, need to cut back their lifestyle, consider returning to work, or some combination of these outcomes.
Options for Tax-Efficient Investing
For some high income earners, tax rates are going up. For others, the biggest change may be a new level of certainty around the tax code. “Now that many of the expiring tax cuts and temporary tax relief provisions have been made permanent, investors have the opportunity to take stock of the situation, create a careful plan, and then put it into practice over the coming years,” adds Sweeney.
While taxes have been top-of-mind for many investors, decades of moderate inflation may have made many complacent about risk that it can pose to their portfolios. History contains several examples of time periods when both inflation and tax rates were on the rise, and the challenge that dynamic can pose for investors.
Two potential strategies designed to help alleviate these concerns include the use of “real return” investments that aim to outpace inflation, and Roth retirement savings accounts, which are funded with after-tax money but offer tax-free earnings, provided certain conditions are metii.
Real Return Investments: Making the case for inflation-sensitive investing
Fidelity's Viewpoint illustrates the impact inflation and taxes have had on portfolio returns when both rose together, and the challenge it can pose for retirement planning. The historic analysis shows why investors who think inflation may be rising may want to consider an allocation to “real return” assets—including TIPS, leveraged loans, commodities, and real estate—instead of a traditional stock and bond portfolio. It also shows the benefits of a Roth account to help manage the risk of rising tax rates and the impact of using both real return assets and Roth accounts together.
‘Asset Location' Just as Important as Asset Allocation
Many investors have several types of accounts. Some are subject to normal tax rules and others have tax advantages. Limits on contributions and withdrawals prevent investors from simply saving everything in tax-advantaged accounts.
The Viewpoint also offers tips to help decide what assets to put into which vehicles. If any of the following four criteria apply, then an investor should review their portfolio for tax-efficiency:
- Paying a high tax rate
- Expectation of lower income tax rates in retirement
- Tax-inefficient investments currently held in taxable accounts
- Investment time horizon of 10 years or more
“It's important not to let the tax tail wag the investment dog,” says Sweeney. “Establishing an appropriate asset allocation is the foundation of a sound investment strategy, and should remain an investor's first priority. The potential impact of taxes should be secondary, but an important second.”
Taxpayer's Guide to Understanding Your 2013 Tax Rates
Fidelity's companion piece to its Get real: focus on real after tax-returns Viewpoint is the Taxpayer's guide to 2013. It details the 2013 tax changes, including two new taxes that were not repealed as part of the fiscal cliff deal: the Medicare payroll tax and Medicare surtax on net investment income.
It also includes a comparison chart of 2013 vs. 2012 tax rates for all income ranges for the following:
- Ordinary income and short-term capital gains
- Long-term capital gains
- Estates and gifts
- Unearned income (Medicare contribution)
- Medicare payroll tax
Fidelity's related perspective on Five big risks to your retirement offers rules of thumb to help investors protect their savings and income from other key risks, in addition to taxes and inflation.
Tax-Smart Investing Seminars
Investors may also attend one of Fidelity's seminars on tax-smart investing at one of its 180 investor centers nationwide. Seminars are designed to help investors:
- Understand the potential impact of taxes on one's portfolio
- Identify strategies to help plan for the taxes affecting one's portfolio
- Review upcoming changes in tax law and understand their impact
About Fidelity Investments
Fidelity Investments is one of the world's largest providers of financial services, with assets under administration of $4.0 trillion, including managed assets of $1.7 trillion, as of January 31, 2013. Founded in 1946, the firm is a leading provider of investment management, retirement planning, portfolio guidance, brokerage, benefits outsourcing and many other financial products and services to more than 20 million individuals and institutions, as well as through 5,000 financial intermediary firms. For more information about Fidelity Investments, visit www.fidelity.com.
Diversification/Asset Allocation does not ensure a profit or guarantee against loss.
The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity does not assume any obligation to inform you of any subsequent changes in the tax law or other factors that could affect the information contained herein. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
Generally, among asset classes, stocks are more volatile than bonds or short-term instruments and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Although the bond market is also volatile, lower-quality debt securities including leveraged loans generally offer higher yields compared with investment-grade securities, but also involve greater risk of default or price changes.
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i Fidelity Investments Greenline Forum Poll, November 2012.
ii A distribution from a Roth IRA is tax free and penalty free, provided the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, qualified first-time home purchase, or death.
A distribution from a Roth 401(k) is tax free and penalty free, provided the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, or death.