This is the time of year when taxpayers should engage in a little last-minute tax planning. One of the most important things they can do to minimize their tax bite is realize some capital losses. They also need to pay close attention to their mutual funds, because fund managers have a lot to say about whether fund investors have taxable gains or losses for the year.
The tax law has long treated capital gains and losses asymmetrically. All net gains are taxed, but the deductibility of losses is limited. In effect, Uncle Sam is your partner if you are successful, taking as much as 39.6 percent of your profits. But if you are unsuccessful, tough luck.
Under current law, taxpayers first deduct any short-term gains -- those arising on assets held less than a year -- against short-term losses. Net short-term gains are taxed like ordinary income at rates up to 39.6 percent. Similarly, long-term gains are netted against long-term losses. Long-term gains, those over 1 year, are taxed at a maximum rate of 20 percent. After this, net short-term losses are used to offset net long-term gains. If an investor has an aggregate loss, up to $3,000 of it can be deducted from ordinary income.
There are a number of problems with this system. The most important is that it discourages risk-taking. Economists have long argued that capital losses should be fully deductible against ordinary income. Indeed, as long ago as 1954, the Economic Report of the President urged Congress to allow full deductibility for losses. "An investor," it said, "would be encouraged to try new fields of operation if he knew in advance that his misfortune, as well as his fortune, would be shared by the federal government."
At that time, only $1,000 of capital losses was deductible. It was fixed at this level from 1942 to 1963. It is worth noting that $1,000 in 1942 would be equivalent to $10,000 today. The loss limit was raised to $2,000 from 1964 to 1977. Interestingly, $2,000 in 1964 would also equal $10,000 today.
Since 1978, investors have been able to deduct $3,000 of losses. Had this figure been indexed to inflation, as many other features of the Tax Code are, it would be $8,000 today. By contrast, the standard deduction has risen by 271 percent since 1978, from $2,800 to $7,600, and the personal exemption has risen 290 percent, from $1,000 to $2,900.
There is legislation pending in Congress that would increase the loss limit. S. 784, sponsored by Sen. Frank Murkowski, R-Alaska, would raise the limit to $20,000 per year. S. 818, co-sponsored by Sens. Orrin Hatch, R-Utah, and Robert Torricelli, D-N.J., would raise the limit to $10,000. And H.R. 1619, sponsored by Rep. Zoe Lofgren, D-Calif., would raise the limit to $8,250. Unfortunately, there appears to be little likelihood of quick action on any of these bills.
That is too bad, because investors are going to have a lot of losses this year. The combined value of stocks on the New York Stock Exchange is down $1.5 trillion since Jan. 1, and the NASDAQ is down another $1.1 trillion. Many investors undoubtedly are going to find that they will have net losses far exceeding $3,000. The law allows excess losses to be carried forward to future years, but that makes them much less valuable than those that can be deducted immediately.
Mutual fund investors may find themselves particularly inconvenienced. They can often find themselves with taxable gains even when the value of their funds has fallen. That is because the law requires all realized gains and losses on stocks owned by mutual funds to be attributed directly to fund investors. If fund managers realized a lot of gains this year, but held on to losses, fund investors could find themselves with big tax bills even though they lost money.
Unfortunately, mutual fund investors generally pay insufficient attention to whether their funds are managed so as to minimize taxes. A new Securities and Exchange Commission rule requires funds to give them more information about taxes, but they still need to be aware that taxes can greatly affect their returns even when they don't sell their shares.
Rep. Jim Saxton, R-N.J., has been working for years to give mutual fund investors a break. H.R. 168 would allow them to postpone paying taxes on gains until they sell their shares. Surprisingly, he has gotten little support from the mutual fund industry, which only just recently endorsed his bill. With a little bit of lobbying by the Investment Company Institute, the trade association for mutual funds, the Saxton bill would probably have been included in the tax bill that passed Congress earlier this year. Its inaction is going to cause mutual fund investors a lot of headaches in April.