Capital gains tax cuts have a chance

Posted: Apr 23, 2001 12:00 AM
Press reports indicate that there is growing support in Congress to cut the capital gains tax. Even Democrats, like Sens. Joe Lieberman of Connecticut and Bob Torricelli of New Jersey, are said to be interested in enacting a capital gains tax cut this year. A key reason for this change in sentiment among those normally opposed to any tax cut for the "rich" is growing complaints from mutual-fund investors, who often pay a double capital gains tax on their investments. The mutual fund is one of the greatest financial innovations of all time. Even those with very modest wealth can, in effect, have professional management of their investments and also get the benefit of a diversified portfolio. Without mutual funds, these advantages would be available only to the very wealthy. Thus, mutual funds are a highly democratic investment vehicle. With the assistance of professional management and the virtue of diversification, anyone with even a tiny amount of saving can take advantage of the higher long-term returns on common stock. Since 1946, investors in a basket of stocks in the 500 largest companies in America would have achieved a compounded annual return of 12.5 percent per year. Without the existence of mutual funds, those with modest wealth would probably be able to invest only in interest-bearing instruments, with much lower rates of return. Someone who invested only in Treasury bills since 1946, for example, would have gotten just a 4.8 percent annual return. Those limited to passbook savings accounts, of course, would have done even worse. Unfortunately, mutual funds have a serious defect from a tax perspective. Whereas an investor in individual stocks has the freedom to choose when and how to realize gains and losses, mutual fund investors do not. For them, such decisions are often made by fund managers. The result is that mutual fund investors often end up with tax liabilities much greater than an investor in individual stocks with the same identical portfolio. This problem arises because of a quirk in the tax law that requires mutual funds to pass through to the fund's shareholders any gains or losses the fund achieves from buying and selling stock. These distributions must be reported by fund investors on their tax returns as income even if they never sold a single share of their mutual funds. As a result, it is quite possible for a mutual fund investor to have taxable capital gains even when he has actually lost money. This was a very common occurrence last year because the stock market peaked in March and then fell sharply for the rest of the year. Thus, if fund managers sold stock early in the year, they probably realized a large capital gain on which fund investors will be taxed. But by the end of the year, the value of the fund itself may have fallen, yielding a net loss for the year. Investors in individual stocks deal with this situation by selling stocks that have fallen in price before year end. Losses can be used to offset earlier gains, and up to $3,000 of net losses can be deducted against other income. Of course, fund managers could do the same thing, thereby minimizing the tax liability of the fund's investors. But they are often reluctant to realize losses for fear of admitting error in their investment strategy. And because the fund itself is not taxed on its gains, managers tend to be oblivious to the tax consequences of their investment decisions. The impact can be enormous. Earlier this year, the Securities and Exchange Commission said that taxes can reduce the average rate of return on mutual funds by 2.5 percentage points per year. A new study by Congress' Joint Economic Committee cites research showing even larger losses. According to the accounting firm of KPMG Peat Marwick, taxes can reduce the performance of mutual funds by as much as 7.7 percentage points, or 61 percent of the pre-tax return. Even a 2.5 percentage point reduction has enormous effects on total returns when compounded over a period of years. The JEC notes that on a $10,000 investment in a fund earning 10 percent before tax, the 2.5 percent reduction in the after-tax return due to taxes would cost an investor $5,000 over 10 years and $25,000 over 20 years. Furthermore, unwary mutual fund investors are often double taxed on the same capital gains. In theory, the basis of their investment (i.e., the purchase price) is adjusted upward when capital gains are distributed, so that when an investor sells shares in the fund he is not taxed again on the same gain. But some investors may not realize that this adjustment has been made and end up paying taxes on the difference between the actual purchase price and the sale price. In this case, they are paying capital gains taxes twice on exactly the same profits. Mutual funds are starting to do a better job of alerting investors to changes in basis for their investors. Some are also trying harder to minimize taxes by being more careful about realizing gains and losses. But in a year like last year, when the stock market was unusually volatile, many mutual fund investors still got stuck with taxes on losing investments. The JEC study reports a number of large mutual funds that were down 20 percent or more for the year, but that still had substantial capital gains distributions. The only way out of this "Catch 22," in which investors are forced to pay taxes on gains that were really losses, is for them to sell their mutual fund shares, using the realized loss to offset paper gains. But that would have to have been done before December 31. Investors who failed to act in time ended up paying extra taxes when they filed their returns this year on fictitious capital gains. Rep. Jim Saxton, a New Jersey Republican and chairman of the Joint Economic Committee, has introduced legislation that would end this bizarre situation. H.R. 168 would defer taxes on most capital gains distributions until a mutual fund investor sells his shares. That would put mutual fund investors on a par with those who invest in individual stocks. This may be a capital gains tax cut that members of both parties can unite behind, so that 2000 is the last year in which mutual fund investors are unfairly penalized for choosing this particular method of investing their hard-earned savings.