Come December, you may care deeply about how your mutual fund profits are taxed.
By that time, however, recently introduced legislation that would give fund investors a sensible bit of tax relief will be dead. Again.
A few folks on Capitol Hill have been fighting a futile battle for years now, trying to change the way funds are taxed, and lowering the burden for buy-and-hold shareholders.
With the market making more gyrations than a belly dancer on speed, there's a good chance that fund managers will make a lot of moves to protect their profits this year, recognizing the gains they have picked up during a long bull market and resulting in big tax bills at the end of the year.
The Generate Retirement Ownership Through Long-Term Holding Act of 2007 - call it the GROWTH Act - was introduced in late June by Rep. Paul D. Ryan, effectively re-hashing a sound proposal that the Wisconsin Republican has put forth several times since 2003.
The bill (H.R. 2796) would allow fund investors to defer capital gains taxes on reinvested distributions until the fund is sold, a change that would simplify personal accounting, make fund investing more attractive and that would put funds on a similar tax plane as stocks.
(A similar bill - H.R. 397 - promotes the same idea, but with limits on how much an investor could receive in distributions without paying taxes. Republican Rep. H. James Saxton of New Jersey has put forth similar legislation for about a decade now that, likewise, has been mostly ignored.)
By law, funds must pass virtually all capital gains - profits from the trades they make - to shareholders each year. Unless the fund is held in a tax-advantaged account, those distributed gains are taxable at capital gains rates, even if the investor never sells the fund or touches the money. (Short-term gains earned when a fund holds a stock for less than a year are taxed at higher, ordinary-income rates.)
So a fund investor can buy-and-hold a fund in a taxable account, roll over all distributions, and end up with a tax bill, even though they never touched the payout. Worse yet, they could owe that tax bill even if the fund lost money over the course of the year.
That could happen a lot this year, barring a significant market resurgence. If fund managers increase their trading to adjust to the topsy-turvy conditions, they'll realize gains accumulated during the bull market. Their fund may lose money or simply lag its peer group during the year, but those gains will be passed through to shareholders, who will have to pay taxes on them.
The issue is not just about the current tax bill. Many investors don't understand how taxes apply to funds and improperly calculate their cost-basis.
Say you invested $1,000 at the start of the year; at the end of the year, the fund's value has held steady, but it pays out $100 in gains, which you reinvest. At this point, you owe taxes on the $100 distribution. Your investment in the fund, however, rises by that $100 you rolled over, so your cost basis is now $1,100; fail to account for the rollovers and you could overpay Uncle Sam when you someday sell the fund.
By comparison, investors in individual stocks pay capital gains taxes only after unloading the stock at a profit. That lets stock investors make active decisions on when to pay gains on their securities, while fund investors are forced to pay up whenever a fund makes a distribution.
Allowing an investor to save in a fund without paying taxes on distributions indefinitely effectively creates the "lifetime savings account" that so many politicos have kicked around in recent years.
For a buy-and-hold investor, it turns a "taxable fund account" into the equivalent of a traditional IRA, without the contribution limits. (Traditional IRAs require payment of taxes only upon withdrawal but allow investors to trade in and out of securities without generating a tax bill; in an ordinary taxable account, every trade is a taxable event.)
From a government standpoint, tax-deferment is revenue-neutral. The government would miss out on current revenues, but get them back in the end, when the investor sells the fund.
There was a lot of optimism in Washington back in 2003 that the issue might gain some traction during the election year of 2004. The silence that has greeted the proposal this year proves that it's not going anywhere this year or next, no matter how popular it could be with voters.
So when that tax bill on your funds arrives this year, consider complaining to your congressman. If investors don't get involved, the best they can hope for is that this kind of legislation gets introduced - and dies quietly - each year; there won't be significant change until average investors push for it.
Charles Jaffe is senior columnist for MarketWatch. His mailing address is: Box 70, Cohasset, MA 02025-0070.