NCPA - National Center for Policy Analysis

Capital Gains Tax Relief For Mutual Fund Investors

April 23, 2001

There is growing support in Congress to cut the capital gains tax, due to complaints from mutual fund investors, who can end up paying capital gains tax on net losses, and often pay twice on the same gains.

While an investor in individual stocks can choose when to realize gains and losses, mutual fund investors often end up with tax liabilities much greater than an investor in individual stocks with an identical portfolio.

Tax law requires mutual funds to pass through to fund shareholders any gains or losses from buying and selling stock. Fund investors must report these distributions as income even if they never sold a single share of their mutual funds. (See Figure)

As a result, some mutual fund investors have taxable capital gains when they actually lost money. This happened last year because the stock market peaked and then fell sharply.

  • The Securities and Exchange Commission says taxes can reduce the average rate of return on mutual funds by 2.5 percentage points per year.
  • A new study by Congress's Joint Economic Committee cites research from KPMG Peat Marwick that shows taxes can reduce mutual fund performance by up to 7.7 percentage points or 61 percent of the pre-tax return.
  • On $10,000 in a fund earning 10 percent, the 2.5 percent reduction in the after-tax return would cost an investor $5,000 over 10 years and $25,000 over 20 years.

Furthermore, unwary mutual fund investors are often double taxed because they do not realize that the basis of their investment (i.e., the purchase price) is adjusted upward when capital gains are distributed.

Rep. Jim Saxton (R-N.J.), JEC chairman, has introduced H.R. 168, which would defer taxes on most capital gains distributions until mutual fund investors sells their shares -- putting them on a par with those who invest in individual stocks.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, April 23, 2001.


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