With everyone arguing about whether
expiring tax cuts
should be extended, huge parts of the tax law are still in limbo.
But it appears that Congress may be preparing to change a
long-hated tax law that has plagued mutual fund investors for
decades.
How to get taxed for doing nothing
There's a huge difference in the way buy-and-hold investors get
taxed on the appreciated gains on their investments, depending on
whether they own individual stocks or shares of mutual funds and
exchange-traded funds. With individual stocks, you're in complete
control of when you pay taxes on any share price appreciation. As
soon as you sell, you'll incur
capital gains taxes
; but if you keep holding your shares, you don't have to pay any
tax. That voluntary deferral is the biggest advantage that
investors have outside tax-favored retirement accounts.
With mutual fund and ETF shares, however, there's a trap that
often snares shareholders. In order to qualify for favorable
Internal Revenue Service treatment, mutual funds and ETFs are
required to distribute all of the dividends and capital gains they
receive each year. Because many funds buy and sell their holdings
fairly actively, the amount of capital gains they realize can be
extremely high, especially in years when the financial markets have
strong returns. Shareholders are then required to include those
distributions as taxable income.
The net result is that long-term investors who own individual
stocks get a huge tax break simply by doing nothing but sitting on
their appreciating shares. Meanwhile, mutual fund shareholders
often get a big year-end tax bill even when they don't deserve
it.
According to Dow Jones, lawmakers are close to a deal to change
the rules. Under the proposal, fund shareholders wouldn't owe
capital gains taxes on distributions that they reinvested into
additional fund shares until they sold them.
Taxation without profit
The way funds get taxed currently is unfair for two reasons. First,
if you're a new investor, you're on the hook for taxes related to
gains the fund realizes -- even if those gains came about long
before you owned the fund. This was particularly painful in 2008,
when many funds declared capital gains distributions for gains from
past years even though the S&P 500 had lost 37%.
Second, in many cases, investors never actually get any cash
from their funds' distributions. Especially with traditional mutual
funds,
reinvesting those distributions into additional
fund shares
is a very common and smart thing for investors to do. And even with
ETFs, an increasing number of brokers allow direct reinvestment of
distributions to acquire more ETF shares.
In fact, because of the particular investments that some ETFs
hold, especially leveraged and inverse ETFs, capital gains
distributions can sometimes represent a huge percentage of the
ETF's value. Look at how much these funds had to pay out two years
ago:
|
ETF
|
2008 Distribution Amount per Share
|
% of Pre-Distribution Share Price
|
|
ProShares UltraShort S&P 500
(
SDS
) |
$11.49 |
13.1% |
|
Rydex Inverse 2x S&P Select Sector
Energy
(NYSE: REC) |
$86.85 |
86.6% |
|
ProShares UltraShort Dow30
(
DXD
) |
$16.06 |
22.0% |
|
ProShares UltraShort QQQ
(
QID
) |
$9.51 |
13.8% |
|
ProShares Short S&P 500
(
SH
) |
$11.98 |
13.8% |
|
ProShares UltraShort Russell 2000
(
TWM
) |
$25.07 |
26.6% |
|
ProShares UltraShort Oil & Gas
(
DUG
) |
$6.08 |
17.5% |
|
ProShares Short Dow30
(
DOG
) |
$8.74 |
11.0% |
Source: Yahoo! Finance.
Admittedly, these and other inverse and leveraged ETFs are
particularly susceptible to this problem, and few investors would
seek to hold these ETFs as a long-term investment, given their
daily focus. In contrast, most standard ETFs use techniques that
help them minimize the tax impact of their trading activity on
shareholders.
But even with small distributions, the point remains the same
for ETFs as with mutual funds: If investors could simply reinvest
distributions into additional shares and avoid capital gains, it
would be beneficial to long-term investors.
Wait and see
Unfortunately,
this isn't the first time
that proposals to remedy mutual fund capital gains taxation have
surfaced. So far, none of them have gotten past this stage. But
with experts noting that this is the furthest any such proposal has
gotten through Congress, optimists can hope that this will finally
be the year that mutual fund investors are freed from having to
dread capital gains distributions.
Our Tax Center has all the information you need to send less
of your hard-earned money to Uncle Sam.
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Fool contributor Dan Caplinger goes into his Heisman pose
when the IRS is around. He doesn't own shares of the investments
mentioned in this article. The Fool owns shares of Short
S&P500 ProShares. Try any of our Foolish newsletters
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