Mutual Fund Investors Unite!

This week Gail discusses a bill pending in Congress that would put more money into mutual fund investors' pockets.

Dear Reader,

If you are a mutual fund investor, please stand up and repeat the following with conviction:


The fact is, the tax code discriminates against 40 million mutual fund investors — specifically those of us who own funds in taxable (non-retirement) accounts.

Here’s what I mean: Let’s say your mutual fund manager is one of the astute ones who recognized five years ago that emerging markets such as Brazil, Russia, India, and China (the so-called “BRIC” countries) were poised to take off. Taking some of the money that you and your fellow shareholders invested in this fund, your manager evaluates which companies in these markets have the best prospects and buys their stocks.

Lo and behold, she’s right: Over the year ending in May, Brazilian stocks are up 62 percent, the Russian stock market rose 107 percent, India’s market is up 47 percent, and China’s stock exchange posted a gain of 44 percent. And that’s after all four markets experienced double-digit declines last month.

Lest you think that this is just a one-year aberration, take a look at the trailing 3-year numbers: From June 2003 through May of this year, Brazil’s stock market has gained an average of 58 percent per year. Russian stocks averaged gains of 45 percent per year. The Indian and Chinese stock markets delivered average annual returns of 30 percent and 36 percent, respectively.

Aware of the Wall Street expression that “Trees don’t grow to the sky,” your manager sells some of those stocks this year, generating handsome long-term capital gains for her shareholders.

Let’s say your share of these profits amounts to $5,000. However, you don’t actually see the money because you, like 90 percent of mutual fund investors, automatically reinvest your capital gains. Instead of cash, you end up with more shares of the fund.

Regardless, come January you will receive Form 1099-DIV that states you “earned” $5,000 in long-term capital gains. And you will have to pay as much as $750 in tax on this. Like most mutual fund owners, you will reach into your own pocket to ante up for Uncle Sam.

If you had bought and sold the individual stocks themselves — instead of doing so indirectly through your mutual fund — you would also owe capital gains. The difference is that you would have also received the cash.

In other words, unlike every other kind of investment, as a mutual fund shareholder you have to pay tax on what your fund earns even though you personally have not sold anything or taken possession of any profit!

Moreover, unlike mutual fund investors, who rely on the expertise of professional investment managers to determine what to buy and when to sell, individuals who directly invest in a stock or a bond can also control the timing of their gains. This allows them to use the tax code to their advantage by offsetting gains on one investment against losses on another.

Mutual funds, by law, — a law more than 70 years old — must pass through to shareholders all income, including capital gains and dividends, that they generate each year. And even if those shareholders leave their gains in their mutual fund, they are taxed as if they had received the money.

Dan Crowley, the chief government affairs officer, a.k.a. head lobbyist, for the Investment Company Institute (ICI), calls that law “archaic and somewhat primitive.” It was written in the mid-1930s, long before mutual funds became the investment vehicle of choice for middle class Americans. And in the view of the ICI, it undermines what is supposedly a top national priority: increasing the personal savings rate, which fell to 0 percent a year ago.

With less than half of working Americans covered by an employer retirement plan, Social Security on the ropes due to the impending retirement of baby boomers, and lengthening life expectancies, the ICI says we should be saving more, not less.

“We’re trying very hard as a country to give people incentives to save for the long-term, and here we are with a tax provision that punishes them for doing that very thing,” says Crowley. “They’re automatically re-investing their gains — which is exactly what we want them to do!”

The ICI, which represents mutual funds and, by extension, mutual fund investors, has been working the halls of Congress to change the existing law. Last year, two sympathetic members in the House of Representative, Republican Paul Ryan of Wisconsin and Democrat William Jefferson of Louisiana, introduced a measure called the “Generate Retirement Ownership through Long-Term Holding, or “Growth” Act of 2005. (In Washington-speak, it’s known as H.R. 2121.) In the hope of generating grassroots support for this legislation, the ICI quietly launched a website,

The Growth Act recognizes the fact that mutual funds are a unique investment. If enacted, it would give mutual fund investors the same tax treatment on their long-term gains as other investors enjoy: the ability to postpone paying capital gains tax until they actually take possession of those profits, i.e. when their mutual fund shares are sold.

Mutual fund company T. Rowe Price ran some comparisons using the actual returns experienced by the average large cap growth fund each year from 1985 through 2004. For the sake of argument, you invest $10,000 in this fund January ‘85. Using today’s tax rates, we assume that throughout this period you are in the 25 percent tax bracket and that long-term capital gains and dividends are taxed at 15 percent. The taxes you owe each year are subtracted from the value of your mutual fund.

The findings? On an after-tax basis, under current law your $10,000 would have grown to $69,715. If the Growth Act had been in place over this timeframe, your investment would be worth $73,701 — almost 6 percent more.

In reality, these tax rates were not in effect over this period. In fact, both ordinary income and long-term capital gains rates were much higher. Moreover, many people would argue that these higher rates are more the norm. Remember, just three years ago the top long-term capital gains rate was 20 percent — 33 percent higher than it is today.

When you re-run the example using the actual (higher) tax rates that applied in each year, the impact of postponing capital gains tax becomes even more apparent. Your $10,000 investment would grow to $69, 029 on an after-tax basis if capital gains were delayed until your mutual fund shares were sold. That’s 15 percent more than the $60,093 you’d have under current law.

The ICI’s Crowley emphasizes that the Growth Act “only applies to long-term capital gains and not short-term gains or dividends,” which would still be taxable annually even if they are re-invested.

Which begs the question: why?

Well, for one thing, it would make the tax treatment of mutual fund dividends the same as that for individual stocks. If you’re a stockholder and the company pays a dividend, this is taxed as income to you in the year the dividend is received.

But my best guess is that including reinvested dividends and short-term capital gains in this legislation would simply cost the Treasury too much. Faced with a looming federal budget deficit, members of Congress are reluctant to approve anything that would shrink the revenue currently being collected. (If only they applied the same reasoning to the spending side of the equation we might really make some headway.)

Crowley admits, “We don’t know exactly what it would cost in ‘lost’ tax revenue,” but says it’s probably in the neighborhood of “tens of billions of dollars.” He emphasizes, however, that this is only temporary. He says the government would eventually collect its money — and possibly more thanks to compounding — when those mutual fund shares are sold.

“It’s important to recognize that this is not a tax cut,” says Crowley. “It’s simply a deferral to align investor expectations with their actions. This is the only investment I’m aware of where investors pay a tax when they haven’t done anything. The tax is based on the actions of a third party over which they have no discretion.”

The Growth Act now has more than 70 co-sponsors (67 in the House and 6 in the Senate) from both sides of the political aisle. After all, members of Congress also invest in mutual funds and pay taxes. But many more need to sign onto this bill if it’s ever going to see the light of day.

Up until now Crowley says issues have taken precedence, such as extending the lower tax rates on dividends and capital gains -- which affects all investors, not just those who invest via mutual funds. But with that signed into law as part of the tax act passed last month (“TIPRA”), the Growth Act should finally be getting some attention.

That’s where you come in. Find out where your senators and representative stand on the Growth Act by visiting the Funding Your Future website. Let them know where you stand.

Hope this helps,

*Members of the baby boom generation or older will recall this line from the movie “Network.” Gen-Xers and younger will have to take my word for it or check out a copy from Blockbuster. (Good luck finding it on DVD.)

If you have a question for Gail Buckner and the Your $ Matters column, send them to:, along with your name and phone number.