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It's Time for Mutual Funds to Join the 21st Century

... in the tax code, that is.

Karen Dolan, 05/13/2010

New proposed financial regulations are rolling out at a rapid pace. It's politically popular to focus on hard-hitting rules designed to teach Wall Street a lesson, and it's not clear if even those will be passed. But in the meantime one simple adjustment to the tax code could go a long way in improving the investor experience for millions of Americans: Mutual fund investors should pay taxes based on when they buy or sell a fund, not each year based on the trading activity of the fund's manager.

How It Works Now
An investor who buys a fund at a net asset value of $10 and sells it three years later for $15 will pay a long-term capital gains tax on the $5 gain, right? Wrong.

Instead, the tax treatment of mutual funds is arcane and needlessly complex. Mutual fund investors pay taxes on capital gains realized within the fund each year. That treatment is unlike other securities where capital gains taxes are paid only after the investor realizes the gain. Investors who own a mutual fund are buying into a pre-existing pool of securities and thus not only must pay taxes achieved while they're in the fund, but also may pay taxes on gains that were accumulated before they ever bought in. And in some perverse cases, investors can get stuck with capital gains even when they are losing money in the fund. For example, in 2000, many emerging-markets funds paid out distributions despite suffering double-digit losses.

Here are three good reasons why legislators should consider updating the tax code:

1. Promote long-term investing.
Perhaps the best argument for a simplified tax code is to promote the benefits of long-term investing for mutual fund investors. Compounding of capital is an investor's most powerful ally. Yet, for those intending to hold their funds for many years, annual taxes on capital gains distributions take small chunks each year rather than delaying the tax hit until shares are sold and after compounding has worked its magic (and, for retired investors, when their personal tax brackets may be lower). Investors have seen their accounts decimated, not once, but twice, over the past decade, and the slow and steady effects of compounding on the full value of their investments can go a long way in helping them restore their savings.

Placing the onus on the end investor could drive different behavior, too. Investors may think twice before hopping from fund to fund or chasing the latest hot performance because they have a real incentive to stick around and ensure long-term treatment of their gains. As it is, investors often have no built-up gain and thus no frictional costs for hopping from fund to fund.

2. Create parity between mutual funds and other investment vehicles.
Mutual funds offer investors diversification and professional management, and many come with a reasonable price tag. Yet, stocks, exchange-traded funds, and separately managed accounts have a leg up in attracting investors because they are inherently friendlier from a tax standpoint. With stocks, investors pay gains based on when they transact and thus can control their own destiny with their buy and sell decisions. The ETF structure allows management to scrub the portfolio of capital gains using inflows or redemptions, thus avoiding capital gains in all but the rarest cases. All of these vehicles are means to an investing end, and there's no good reason why mutual funds--one of the more shareholder-friendly and widely owned investment types--should sit at such a disadvantage in this regard.

In fact, the United States would not be alone if it made this change. Most countries tax their mutual fund equivalents just as they do other investments, or they don't tax them at all, thus encouraging investing.

3. Simplify tax reporting for a large percentage of Americans.
A recent study released by the Investment Company Institute estimated that 87 million investors owned mutual funds in 2009 and 69% of those investors held some funds in a taxable account. So, keeping tabs on the cost basis of mutual funds is a gargantuan task for a large portion of the population. Most brokerage platforms and advisors help investors track cost basis, and new laws are in the works ensuring they do it.

There are real costs to all of that complicated record-keeping, however. And investors who make a switch from one brokerage platform or advisor to another still face a complicated mess of paperwork and calculations to figure it out. Simplifying the tax treatment of funds would save time and money for a lot of people at tax time.

The Time Is Ripe
One of the arguments against this change typically has been that it would cause the federal government to lose a source of current tax revenue. Yet, this adjustment would change the timing and calculation of capital gains, not the fact that they're paid. This could be an opportune time for Washington to make a change without a big hit on its own bottom line. Most mutual funds haven't been paying out big capital gains and likely won't for a few years. 60% of the mutual fund universe is still carrying losses forward from 2008. We estimate the potential capital gains exposure for every fund we track and found that the median figure across our equity fund universe is negative 6%.

Karen Dolan is Morningstar's director of fund analysis.

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