Washington is probably not going to give financial advisors much help this year with fighting capital gains taxes on clients mutual funds.
Rep. Jim Saxton, R-Cherry Hill, N.J., the chairman of the House Joint Economic Committee, recently called the current treatment of fund capital gains distributions “discrimination” in a press release that tried to explain the issue to the general public.
“Mutual fund investors are subject to tax on capital gains distributions even if their mutual fund shares fall in value,” Saxton says in the release.
Saxton has introduced H.R. 168, a bill that would allow individual taxpayers to exclude as much as $3,000 in mutual fund capital gains distributions from taxable income, and circulated a second proposal that would exclude $5,000 in gains from taxable income.
So far, though, because of the federal budget problems and the new emphasis on national security issues, the environment for the two proposals is so challenging that “neither one has had a hearing,” according to John Collins, a spokesman for the Investment Company Institute, Washington. “Neither is even scheduled for a hearing.”
The U.S. Securities and Exchange Commission has tried to give investors some relief.
An SEC regulation that took effect Feb. 15 requires fund companies to publish after-tax return figures in the risk/return section of each fund prospectus, according to the text of the final notice.
But advisors will have to continue to rely heavily on traditional strategies for helping clients cope with taxes on mutual fund distributions, experts interviewed say.
Two Different Objectives
Fund managers get complaints about big capital gains distributions and other fund distributions because they serve two types of accounts.
One type consists of retirement accounts, college savings accounts and other tax-deferred and tax-exempt accounts. Owners of these accounts hold about two-thirds of U.S. fund assets.
The other type of account, the taxable mutual fund account, holds about one-third of U.S. fund assets, ICI says.
The tax rules are complicated, but the owner of a taxable mutual fund account could pay a maximum tax rate of 20% on 2001 “long-term capital gains distributions,” or gains paid as the result of the fund selling securities, according to Internal Revenue Service Publication 564: Mutual Fund Distributions.
“Most mutual fund managers treat tax-deferred and non-tax-deferred accounts as if they have the same investment objective,” says William E. Donoghue, chairman of W.E. Donoghue & Company Inc., Natick, Mass. “Thats absolutely absurd.”
Owners of tax-exempt and tax-deferred mutual fund accounts rarely worry about taxes on fund distributions.
The typical holder of a tax-deferred fund probably wished fund managers had sold far more stocks and generated far bigger capital gains in 2000, Donoghue says.
But paying income taxes on fund distributions irritates owners even when returns are strong, and it infuriates owners in years when fund assets actually lose value, according to reports by Eaton Vance Corp., Boston, a fund company.
Many retail investors ended up paying big capital gains taxes on money-losing funds in 2000.
Fund managers bought stocks in the mid-1990s, when prices were low, then held the stocks as prices soared. Because the prices were higher, the funds carried large amounts of “unrealized capital gains” or “embedded capital gains.”
Many consumers put money in the funds in late 1999 and early 2000, when stock prices and fund net asset values were sky-high.
Then, the market plunged. Managers sold their most expensive stocks to raise cash and guard against more drops in prices.
The fund managers recorded big gains, because the sales prices were far higher than the original prices paid for the stocks in the mid-1990s.
Managers passed the gains on to all investors, including new investors who reinvested all distributions, in the form of capital gains distributions.
But NAVs at many funds were lower at the end of 2000 than they are at the beginning.
The result: new investors ended up with a combination of lower account values and big, taxable capital gains distributions.
Fund companies paid out a record $325 billion in capital gains distributions in 2000, up from $238 billion in 1999, according to ICI.