Bill Offers Tax Break for Fund Owners

Mutual fund owners would get a break on capital gains taxes under a bill introduced in the House on Thursday. The bill, sponsored by Jim Saxton (R-N.J.), would exempt the first $3,000 of mutual fund distributions from capital gains taxes, while couples would get an exemption for the first $6,000.

Under current law, mutual fund owners pay tax on capital gains realized by the fund, even though they won’t see those gains until they sell their shares. By contrast, owners of individual stocks are not taxed until they sell the stock at a profit.

A recent study commissioned by Congress’ Joint Economic Committee found that the current mutual fund tax structure can reduce the rate of return to investors by 10% to 20%.

Under current law, when mutual funds sell securities for a gain, they pass on those gains to shareholders, who must pay annual taxes on them, even though shareholders haven’t done any selling.

“Even if the value of their shares has declined or they have owned them for only a short time, they can be slammed with a huge tax liability,” Saxton said.

Though taxpayers who sell their mutual fund shares would still pay tax on any gains there, the exclusions would shield most middle-income investors from immediate taxation and potential double taxation on capital gains distributions.

Investors often overpay the Internal Revenue Service because they forget to add those capital gains distributions to the initial cost of the shares they bought when calculating their profit.

An investor might buy shares of a mutual fund for $10,000, as an example, then receive another $10,000 in capital gains distributions, which they reinvest over 10 years. If the investor sells the fund in the 11th year for $22,000, he or she should add the original $10,000 plus the $10,000 in reinvested capital gains distributions, bringing total purchases to $20,000 and resulting in $2,000 of taxable capital gains. Those who fail to add in the extra $10,000 end up with $12,000 to pay taxes on.

Geoff Bobroff, an investment management industry consultant in East Greenwich, R.I., said that although the legislation would have a “clear benefit” to the fund industry, it could prove difficult to pass.

With about 60% of long-term industry assets held in tax-deferred programs such as individual retirement accounts or 401(k) programs, only about 40% of industry assets would be affected by the bill, he noted.