IN REACHING a compromise on tax relief, Congress and the Bush administration ignored fund investors.
That's not entirely a bad thing because fund investors will benefit from tax-rate reductions and expanded retirement-savings opportunities. But after a year in which funds created countless tax headaches for shareholders, investors hoping for something more should now come to grips with what they are not getting.
A few weeks ago, the Joint Economic Committee concluded a study that suggested investors should be allowed to defer tax on at least some of the capital gains that their mutual funds distribute. That conclusion hardly was surprising, since Rep. Jim Saxton, a New Jersey Republican and the incoming chairman of the committee, has introduced a bill to allow just that. Saxton's proposal would allow investors to receive up to $3,000 per person in distributions and not pay current taxes on that money.
It's a popular idea among consumers, if only because it would curtail much of the confusing way that funds are taxed. Each year, a fund must pass out all capital gains - the profits it earns on trades - to shareholders who, in turn, must pay the taxes due on those gains (unless the fund is held in a tax-deferred retirement account). The gains are taxable even if the money is reinvested and the consumer never touches the money.
Last year, gains payouts were huge as many fund managers got defensive in the down market, selling longtime winners to lock in profits. That made this year's tax season particularly onerous, with many fund investors suffering losses but still having a tax bill to pay. Indeed, the mutual fund's status as a "pass-through" vehicle is at the core of the debate over "tax-efficiency," where a fund's performance is measured not only on its raw returns but also on how much an investor actually gets to keep after paying Uncle Sam.
Combine the hue and cry from gains paid out last year with the mutual fund's status as the dominant investment vehicle for ordinary investors, add Saxton's bill representing tax-deferral (rather than the big revenue decline of a full tax cut), and it's easy to see why some observers thought this legislation would breeze into being with extensive bipartisan support. It may come to that some day, but not yet.
"The administration has made it clear they are not interested in anything with capital-gains relief right now," says Rande Spiegelman, senior manager at KPMG Personal Financial Planning in San Francisco. "You start talking capital gains, and the rhetoric really gets elevated. The Bush administration wanted to push the basic tax package and budget without muddying the waters.
"Any time would be a good time to do this as far as fund investors are concerned, but it's just not the right time politically right now." The right time will not come until a few things happen.
For starters, the bill has to get broader support from some heavy hitters. The Joint Economic Committee sounds good, but it's actually something of a weakling on Capitol Hill, and it's not known for writing tax legislation. Further, the sponsors of Saxton's bills, to date, are mostly from his own party.
The fact that the bill has been referred to the House Ways and Means Committee is not enough; it has to be embraced by that powerful group.
Next, it needs to be written better. Ideally, Saxton's group - assuming the bill fails this year and gets reintroduced in 2002 - will drop the $3,000-per-person limit. It's not just that this would enhance the tax savings, it also would ease the accounting requirements that individuals (and/or fund firms) would face if this became law. The more restrictions, the more complicated your future tax return (even if the legislation lowers your taxes due).
Third, the bill needs industry support. The Investment Company Institute, the industry trade association, hasn't gotten behind the bill yet, in part because of the uncertainty over whether the accounting requirements would be a costly burden on the fund firms.
Lastly, it may take another year like the past one from the standpoint of gains payouts. The market's decline last year and much of this year took a lot of unrealized gains out of the market, meaning that 2002 distributions, on average, are likely to be lower than what happened last year's.
That means there may be less noise from disheartened investors, and less impetus for the politicians to step up.
My forecast: Look for a funds tax cut in 2003 or 2004, a little closer to the next big election, when it will be a good compromise on how to cut capital gains without eliminating those taxes entirely.
Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at firstname.lastname@example.org or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.