Mutual funds: Abandon hope, all who wish for fund tax reform

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 any time soon.

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 here 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.

It creates some odd situations, like when an investor buys into a fund that has racked up gains, which the new shareholder is responsible for even despite having not shared in those profits, or how a fund can lose money on the year but still generate a tax bill as managers shift strategies and lock in long-term gains as the overall market is declining.

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

That's how it works with stocks, when an investor only 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; functionally, 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 and making it that an 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; it's 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.

There are worse things than receiving taxable distributions, however. 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 the 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 that change the requirements 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 themselves having an increasingly difficult time accurately tracking their oldest investments, increasing the likelihood that they don't properly adjust cost-basis numbers to reflect distributions that were received, taxed, and reinvested.

You'd like to think legislators could have fixed both problems at once, but that would have been too logical.

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, if only because traditional funds are the investment for the average guy which, in an election year, means the average voter.

Ironically, the bi-partisan 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 a common ground, they can't kick it around like a political football; while the individual investor would win through reform, neither political part 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 until the next time the stock market tanks, fund investors have losses to show in their accounts, but capital gains taxes to pay for profits that never showed up in their pockets.

In short, no pain for investors, no chance of gain for reform. And pain in the butt doesn't count, which is why investors will be stuck with the current system for the foreseeable future.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at Box 70, Cohasset, MA 02025-0070.