Coping with the tax cost of mutual funds

The stock market tanked, again, today. Then it recovered some. But it still closed below 10,000 and it’s likely to keep bouncing up and down for the rest of the year.

If you did an EKG on investors, you’d see that same kind of irregularly as they try to cope with the ups and downs of their investments.

And the hearts of many might just explode, along with their anger, next tax filing season when they discover that although the value of their holdings went down for the year, they’ll owe taxes.

That’s not an unusual occurrence for mutual funds owners.

Back in October 2001, I wrote a story (read it here) about the tax predicament that mutual fund investors find themselves in each year. As I noted, "In the investment world, taxes are the price you pay for success. And sometimes that success — and the accompanying
tax bill — come as a total surprise."

But if you’re not in total control of your investments, which fund holders aren’t, then you pay for someone else’s actions with your money. Seven years ago, in discussing the tax surprise awaiting fund owners, I wrote:

That’s the predicament that some mutual fund shareholders could find themselves in when the books are finally closed on this turbulent market. Fund managers sell assets throughout the year, passing along a portion of any gain from those sales to the individual shareholders as capital gains distributions. That means the shareholders could owe the Internal Revenue Service even though their fund’s overall value may have dropped in a chaotic market.

Same song, same verse: As the saying goes, the past is prologue. And it looks like a lot of us are going to be paying taxes next year on holdings that have lost value.

MarketWatch columnist Chuck Jaffe has written an open letter to presidential candidates John McCain and Barack Obama regarding the unfair tax burden on fund investors. He says:

We’re living through horrible economic times and a miserable stock
market, and we’re about to get slapped once again. It’s not the next
pending collapse — the one that will soon force the next rescue plan
— it’s the ordinary tax system kicking us for our troubles.

More than 90% of all mutual funds have lost money this year, according
to the researchers at Morningstar Inc. As fund managers have been
flailing to stay afloat, they have been trading like crazy, generating
capital gains and, in turn, creating a tax liability for investors.

Rather than continuing to treat funds as pass-through entities, Jaffe suggests the law be changed to allow fund investors defer capital gains taxes on reinvested distributions until the fund is sold. This ends the "taxable gains on losing funds" situation, eases the accounting burden on investors and puts mutual funds on a similar tax footing with stocks.

For the last few years, bi-partisan legislation to do just this been stalled in Congress, writes Jaffe. "Best of all, the plan is revenue-neutral — it eases the burden on investors now, but brings in the same revenues over time — meaning you each can support it, claim it as a middle-class tax cut and know that it’s not going to create additional tax burdens elsewhere over time."

If you’re an investor who fears what tax time might bring for your battered mutual funds, let the presidential candidates and your current (or future, if there are post-Nov. 4 changes) Senators and Representative know that you support this tax law change.