How about tax relief for mutual fund investors?

Your Funds

July 30, 2000|By CHARLES JAFFE

While the public has been focused on legislation that could wipe out the marriage penalty and end the estate tax, a lesser known tax bill has been introduced that would be a windfall to virtually everyone who owns mutual funds.

Introduced late last month by the Joint Economic Council, the Mutual Fund Shareholders Tax Relief bill not only serves to get fund owners cheering, but it points out some of the lunacy of the way people pay taxes on funds now.

Essentially, this bill would allow fund owners to exclude up to $3,000 in capital gains per person (so $6,000 for a married couple) received from funds in which they reinvest those gains rather than taking the cash.

That all sounds complicated, but stick with me, because someday this bill could be money in your pocket.

The way fund investments are taxed is confusing. Mutual funds are considered "pass-through" investments. So any time a fund racks up capital gains or dividends, it must pass those monies along to shareholders, who then pay the taxes due.

Even if you reinvest the money you get in capital gains (which represent a fund's accumulated profits from selling securities) and never touch any of the money involved, you owe taxes on any profits distributed by your funds. What's more, it's possible to have a fund lose money yet distribute capital gains, leaving the shareholder down (in the fund) and out (of the money needed to pay the tax bill).

This whole situation is why the fund industry got into a debate over "tax efficiency," whereby some funds are run in a fashion that reduces gains distributions and tax burdens. Critics often say one major weakness in funds is the inability to control taxes; you can buy-and-hold a stock and never face a capital gain until you sell, but a fund held for the same period could create a tax liability every year you own it.

Because the effect of taxes can make a fund's real return (what you get after paying Uncle Sam) vary as much as 20 percentage points from its pre-tax return, the Securities and Exchange Commission has proposed requiring funds to show shareholders their performance on an after-tax basis.

The new shareholders tax relief bill would make that moot for average investors.

The first $3,000 in gains distributions per year would be excluded from taxes in the current year. You would still owe taxes on those gains when you sell, but fund ownership could be much more like stock ownership in that you could defer capital gains taxes until you sell.

What's more, the $3,000 limit is set to grow with inflation.

Politically speaking, this bill should have a ton of support, especially in an election year. It reaches out and covers the 50 million households that own mutual funds in taxable accounts (outside of retirement plans and individual retirement accounts), which is a far sight more than are affected by the proposed repeal of the estate tax.

What's more, affected investors are ordinary folks, the soccer Moms and working-class guys who make up the bulk of fund investors. That makes it a no-brainer for bipartisan support.

And unlike the estate tax or the elimination of the marriage penalty - where some married taxpayers owe more filing a joint return than if they filed as two single individuals - the proposed fund legislation is revenue neutral, with the taxes being deferred. Uncle Sam still gets his money; he just has to wait until you sell the fund.

By only allowing the exclusion on dividends reinvested in the fund, the legislation encourages investors to roll over those gains rather than take them in cash. Every legislator seems to be looking for ways to give people incentives to save these days; this fits the bill.

Simplifying tax returns for fund investors is not this bill's intent, but is a bonus result. (For people who exceed the exclusion level, taxes will not be more simple this way.) While there is no significant downside to the fund shareholders tax relief bill - there may be grumbles from other industries hoping for similar treatment, but there appears to be little opposition - immediate passage remains a long shot.

With the legislative session coming to an end, sources on Capitol Hill say they think it's highly unlikely the bill can get by in 2000.

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