Time for Tax Fairness for Fund Investors

With Democrats controlling the presidency and Republicans the legislative branch, political analysts are trying to identify policy areas where the two parties might reach agreement. Here is a suggestion for our political leaders: Work together to provide tax fairness to mutual fund investors.

Mutual funds have many terrific qualities, including (at times) low costs and broad diversification, but tax inefficiency can offset some of those benefits. By law, mutual funds are required to distribute nearly all of their realized gains each year. Even when reinvested into the funds, those capital gains distributions can trigger significant tax bills for investors who hold mutual funds in taxable accounts. Worse yet, many investors neglect to "step up" their cost basis to account for distributions on which they have already paid taxes--this recordkeeping is complicated!--so they pay tax on the gains a second time, when they eventually sell the fund.

As a result, investors who do what they are supposed to do--buy and hold funds for the long term, reinvesting their capital gains distributions--can face enormous tax bills. Even investors who have only recently purchased a fund sometimes receive large distributions for portfolio gains that preceded their ownership. In perhaps the worst case of all, an investor may own a fund that has declined in value since he or she bought it but that nevertheless makes a large capital gains distribution.

This puts lower- and middle-class investors at a significant disadvantage. Wealthier investors have enough assets to build their own diversified portfolios of equities, which generally provide them an opportunity to control the timing and size of realized capital gains. But for investors of more moderate means, mutual funds offer the only opportunity to achieve this type of diversification.

The unfavorable tax treatment of mutual funds is particularly outrageous when compared with the taxation of certain hedge fund and private equity fund performance fees. Under federal tax rules, hedge fund and private-equity managers can defer taxes on "carried interest" for many years. Even then, these wealthy hedge fund and private equity fund managers pay only capital gains rates on what, in reality, is ordinary income that should be taxed at a rate nearly twice as high.

The carried interest treatment is inconsistent with how most people are taxed on compensation for services (as regular income). People pay certain taxes on their income, and they pay other (usually lower) taxes on their investment capital. These are the rules that apply to everyone else, so why should one group of people get to treat their income like capital gains? As tax expert Daniel Shaviro, a law professor at New York University Law School, told The New York Times: "It's an outrageous loophole. No reputable person will say otherwise unless they're getting paid."

For those of us who are not getting paid to defend the indefensible, the correct course of action is clear: The government should close the carried interest loophole, with the proceeds helping to pay for removal of the punitive taxes borne by fund investors.

Although key members of Congress have proposed making these tax changes, so far their efforts have foundered. Among others, former House Ways and Means Committee Chairman Dave Camp proposed taxing carried interest as ordinary income, in the context of his 2014 rate-lowering tax-reform package, but his bill did not receive serious consideration. For years, former New Jersey Rep. Frank Saxton regularly proposed exempting at least a portion of capital gains distributions from taxation, but he left office in 2009 without achieving his goal.

It is high time for Congress and the president to take action to eliminate these inequities. If you agree with this position, please take a few moments to click here and sign a White House petition calling for tax fairness for fund investors. Then forward this column or the White House petition link to your friends, family, and colleagues. If we can obtain 100,000 signatures in 30 days, it will not only trigger an official White House response, but it will place investor interests front-and-center for our political leaders.