NCPA - National Center for Policy Analysis

Capital Gains And Mutual Fund Investors

October 4, 2000

Mutual funds have advantages for investors, including the ability to diversify risk. But when it comes to taxes, there is a downside compared to buying stocks directly. Under current law, investors who never sold any of their shares can incur additional tax liabilities.

When individual stocks are sold for a profit, owners incur a tax liability on their capital gains. But investors are able to minimize capital gains taxes by selling stocks with gains and losses in the same year, using the losses to offset the gains.

But mutual fund investors don't have this flexibility because fund managers decide when and how to realize gains and losses -- which are passed through to those who invested in the fund, along with the tax liability.

  • In tax year 1999, taxpayers received capital gains distributions of $237 billion, according to the Investment Company Institute.
  • With the maximum capital gains tax rate at 20 percent, this means that at much as $47 billion in capital gains taxes were paid on their 2000 returns.
  • Many analysts blamed the stock market's sharp downturn in April to investors selling fund shares to get cash to pay taxes on capital gains distributions.

Obviously, a simple way of relieving taxpayers would be to treat mutual funds the same way that individual stocks are treated for tax purposes. Mutual fund investors would only be liable for capital gains taxes when they sell their mutual fund shares. Reinvested gains would be treated as unrealized gains for tax purposes.

Earlier this year, the Joint Economic Committee of Congress issued a study showing how such a tax change would simplify the taxation of mutual funds. It would also increase the after-tax return on mutual fund investments, thus encouraging greater saving and investment by small investors.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, October 4, 2000.


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