A number of press reports have recently warned mutual fund investors about the problem of capital gains distributions on their fund shares. Under current law, such distributions can impose additional taxes even on investors who never sold any of their shares. George W. Bush would be wise to make relief of this problem an element of his tax package.
As everyone knows, a mutual fund is a company that buys and sells corporate stock on behalf of investors in that fund. Investors can buy and sell mutual fund shares just like individual stocks, and the variety of funds available for investment is almost as great as the universe of the stocks they own.
Mutual funds are an excellent investment vehicle for small investors. They get the benefit of professional management of their assets, they can often buy in smaller increments than would be efficient if they were buying shares directly, and they are able to diversify their portfolios very easily. For these and other reasons, Americans now have more than $2 trillion invested in mutual funds, a ten-fold increase over the last 10 years.
Unfortunately, there is a downside to mutual funds when it comes to taxes. When investors buy corporate stock directly, no tax is paid, no matter how much the stock rises in value until they sell the shares. This gives investors the power to decide when to realize gains and losses. Often, they are able to minimize capital gains taxes by selling stocks with gains and losses in the same year, using the losses to offset the gains for tax purposes.
But with mutual funds, investors lose this flexibility, because fund managers decide when and how to realize gains and losses. When managers sell stocks owned by a mutual fund for a gain, the fund itself does not pay capital gains tax on them. Instead, the gains are passed through to those who invested in the fund. They must then pay taxes on such gains, even if they never sold any of their mutual fund shares and had all gains reinvested.
Investors can minimize their tax bite by investing in tax-efficient funds. In general, these are mutual funds that buy and hold stocks, rather than trading them frequently. Index funds, which track things such as the Standard and Poor's 500 index, tend to be among the more tax-efficient funds. But even here, there can be significant differences in the tax liability of investors, depending on which mutual fund company's index fund they bought.
Unfortunately, in recent years, fund managers have tended to become more and more active in their management of fund portfolios. Stock turnover among mutual funds, which historically averaged about 17 percent per year, has risen to 90 percent. This means that 90 percent of the stocks owned by a typical fund at the beginning of the year will have been sold before year end.
The result is that mutual fund investors have gains attributed to them on which they must pay taxes. And since, in many cases, they did not sell any of their mutual fund shares, they may not have any cash with which to pay the tax. Consequently, many investors wait until April 15 to cough up the money, rather than filing an estimated tax payment when the capital gains distribution was made. This leads to forced sales of mutual fund shares in March and April each year and also threatens taxpayers with penalties from the IRS.
In tax year 1999, taxpayers received capital gains distributions of $237 billion, according to the Investment Company Institute. With the maximum capital gains tax rate at 20 percent, this means that as much as $47 billion in capital gains taxes were paid on their 2000 returns. Many analysts blamed the stock market's sharp downturn in April to investors selling fund shares to get cash to pay taxes on capital gains distributions.
Obviously, a simple way of relieving taxpayers would be to treat mutual funds the same way that individual stocks are treated for tax purposes. Mutual fund investors would only be liable for capital gains taxes when they sell their mutual fund shares. Reinvested gains would be treated as unrealized gains for tax purposes.
Earlier this year, the Joint Economic Committee of Congress issued a study showing how such a tax change would greatly simplify the taxation of mutual funds. It would also increase the after-tax return on mutual fund investments, thus encouraging greater saving and investment by small investors. Congressman Jim Saxton, New Jersey Republican, has introduced legislation that would tax mutual funds only when fund shares are sold.
Since this is the time of year when mutual funds generally announce their capital gains distributions, now would be a very good time to make an issue of this problem. Unfortunately, the congressional leadership has chosen instead to pass tax bills that Bill Clinton has promised to veto, rather than those he might sign. And Republican presidential candidate George W. Bush chose not to include any capital gains tax cut in his tax plan.
With 50 percent or more of Americans now having investments in the stock market, many through mutual funds, a tax cut targeted at this New Investor Class might resonate better than Bush's proposed across-the-board tax rate reduction. There is certainly no reason why he cannot talk about adding such a provision to his plan. It would be good economics as well as good politics.