Chuck Jaffe Get email alerts

Taxes on mutual funds are a mess

Published: Apr 15, 2012 12:01 p.m. ET


Commentary: Abandon hope, all who wish for fund tax reform



BOSTON (MarketWatch) — As mutual fund investors put the finishing touches on their tax returns for 2011, they should also give up hope that the confusing, complex way funds are taxed will get better anytime soon.

Buy low, sell high? Forget it

MarketWatch columnist David Weidner visits Mean Street and spotlights the sentiment that the markets are unfairly tilted against small investors, and it is difficult for them to buy low and sell high. Photo: AP.

An increase in capital-gains rates is on the horizon in 2013, adding injury to the insulting way taxes are calculated on traditional funds.

The issue is that mutual funds are “pass-through obligations,” and investors who hold them in taxable accounts must calculate their taxes each year based on the trading activity inside the fund.

This creates some odd situations, such as when an investor buys a fund that has racked up taxable gains, for which the new shareholder pays despite not sharing in those profits, or how a fund can lose money on the year but still generate a tax bill as managers lock in gains as the overall market is declining.

Losing gains

Those issues could be eliminated — and long-term investing in funds could be promoted — by allowing investors to pay taxes based on when they buy and sell.

That’s how it works with stocks: an investor owes capital gains taxes when they sell shares at a profit. That’s also the typical model for exchange-traded funds, which essentially are funds built to trade like stocks. The structure of an ETF allows management to use inflows and redemptions to zero out the portfolio’s capital gains, thereby avoiding interim taxes the vast majority of the time. An ETF investor only faces gains when they sell at a profit.

It’s also how it works in virtually every country that has a mutual fund structure for ordinary investors. This is the rare area where the U.S. regulatory or tax structure for funds is worse than what is found elsewhere.

The issue affects a lot of people, some 90 million investors with $4 trillion in taxable accounts in 2011, according to a recent study by the Investment Company Institute, a fund-industry trade group.

There are worse things than receiving taxable distributions. Losing money comes to mind, for example, but so does paying taxes twice, which sometimes happens to investors under the current system. If a shareholder pays taxes on distributions they get during the calendar year, but fails to adjust their cost basis when they roll those dividends back into the fund, they wind up paying taxes on the distributions twice.

New rules for how fund companies track share costs should eliminate that problem, or make it worse, at least for distributions received and reinvested before 2012.

The new rules require fund companies to keep a shareholder’s cost record, but only for purchases made beginning this year. Over time, investors will find it increasingly difficult to track their oldest investments, raising the likelihood that they don’t properly adjust cost-basis numbers to reflect distributions that were received, taxed, and reinvested.

In need of repair

You’d like to think legislators could have fixed both problems at once, but that would have been too logical. Learn about the new cost-basis rules and what fund investors should do about them now.

Congress has considered the fund-taxation issue, and even made some headway with reform bills proposed over the last few years; ultimately, however, the legislation never gained serious traction.

Part of the issue is that “easing a tax burden” smacks of tax cuts and, therefore, becomes politicized. In this case, however, there’s no change in the tax rate, just in the timing of when an investor owes something on gains. Ultimately, a change would be revenue-neutral, although it would allow investors presumably to put off some current tax obligations (under the existing rules) for years or even decades.

The timing, however, would be good for investors now, as many funds still are carrying forward losses from 2008, meaning that there hasn’t been as much collected in gains taxes on funds as there is likely to be, say, next year, as trading profits from the market’s recent rally overcome those past losses.

You would also think it would be good timing, politically speaking. Traditional funds are the investment for the average guy, which in an election year means the average voter.

Ironically, the bipartisan support that existed for the reform bills that stalled in Congress actually hurts the chance of making a change now. Since both sides can find common ground, they can’t kick it around like a political football; while the individual investor would win through reform, neither political party could claim a win, vastly diminishing the political interest in the issue.

Sadly, it leaves fund investors with the current system, and no impetus for change. In short, pain for investors, no chance for gains from reform.

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