Is the Tax Bite Too Big on Your Mutual Funds?
Maurice Algazi barely knew what hit him. A strategic planner at a big food-service company and a careful investor from Gaithersburg, Md., Algazi nonetheless was shocked a couple of years back when his Franklin Templeton mutual fund made a huge capital-gains distribution. "It was pretty ugly," he told me. "My [taxable] income jumped by 30%." The next year, Algazi had to go through the rigmarole of estimating his taxes quarterly for the Internal Revenue Service.
Along with legions of other sadder-but-wiser fund investors, Algazi has shifted his money into more tax-efficient funds and begun to consider using an alternative to funds, such as an individualized account managed just for him. Good moves. But this is a case where it will take an act of Congress to fix mutual funds' maddening practice of saddling investors with unexpected tax bills.
Happily, legislation is in the works to do just that. It's called H.R. 168, sponsored by Representative Jim Saxton (R-N.J.). The bill would let most mutual-fund investors defer paying taxes on reinvested capital-gains distributions until they sold their fund shares, the same tax treatment that owners of stocks and most other financial assets enjoy.
Saxton, who has represented a slice of central New Jersey since 1985, chairs the House and Senate's Joint Economic Committee. He told me he came up with the bill after going over his taxes with his own accountant a couple of years ago. "He said: `Your capital gains from your mutual funds are X, Y, and Z.' And I said: `How can that be? I didn't sell any mutual funds."'
The congressman--like Algazi, perhaps like you, and definitely like yours truly--was shocked to learn how mutual-fund holdings are taxed. As the law stands now, investors owe a capital-gains tax if they sell fund shares at a profit. And they owe income tax on any distributions a fund pays out of dividends on stocks it holds or interest it earns on taxable bonds. But they also must pay a current tax on a fund's capital-gains distributions.
Each year, if the trades in a fund's portfolio realize more capital gains than losses, the fund must pay out to investors their share of the net capital gains. A tax on those gains is due even if a fund holder never sees any cash but instead elects to reinvest the distribution in more fund shares. Most investors do reinvest. The fund industry's trade group, the Investment Company Institute, reports that 91% of capital-gains distributions in 2000 got plowed back into funds. That rate doesn't vary much year to year.
Under Saxton's proposal, funds would keep paying out any net capital gains they realize each year. But fund holders who chose to reinvest their distributions would be able to defer the tax on up to $3,000 in capital gains each year ($6,000 on joint returns) until they sold their shares in the fund. Because fund holders could keep more capital invested, their holdings could compound faster, with real benefits to long-term investors (table).
As you've probably guessed, H.R. 168 offers no free lunch. Some investors could find their tax record-keeping turn even more onerous than it is now. And supporters estimate the cost to the Treasury at up to $47 billion over 10 years. That's "not insignificant if we're looking at deficits" instead of surpluses in the federal budget, says Vanguard Group tax expert Joel Dickson. Just the same, Vanguard and such other fund complexes as Janus and T. Rowe Price took the unusual step of encouraging support for the bill among their clients.
As sensible as H.R. 168 may seem, it is far from a slam dunk. Saxton said he's heartened by garnering bipartisan support, plus friendly noises from the Bush Administration. But if you own mutual funds in a taxable account, it would not hurt one bit to make some favorable noise of your own on behalf of H.R. 168.