The Taxation of Mutual Fund Investors: Performance, Saving and Investment

Abstract

In order to increase personal saving and investment and to promote tax neutrality among various investment vehicles, the tax treatment of capital gains unrealized by mutual fund shareholders should be modified. The current policy of taxing mutual fund capital gain distributions unfairly discriminates against taxpayers seeking the investment benefits of diversification through mutual funds instead of through direct ownership of stocks. Therefore, the practice of taxing forced distributions of capital gains to mutual fund shareholders should be changed to allow for a deferral of taxation on reinvested capital gain distributions. Until shareholders realize a capital gain through the sale of an asset, no tax liability should incur. Since mutual funds are a popular vehicle for saving and investment of middle-income households, this tax reform would greatly increase the incentives for these people to invest and save for their future by increasing their after-tax rate of return. A tax deferral on mutual fund capital gain distributions as proposed in H.R. 168, sponsored by Rep. Jim Saxton (R-NJ), could increase the after-tax return by almost 15 percent over a 30-year period for many mutual fund shareholders. For a hypothetical taxpayer with an initial $10,000 investment in a mutual fund that returns 10 percent a year, the deferral on capital gain distributions as proposed in H.R. 168 would amount to $15,055 over a 30-year period after taxes. This amounts to approximately 150 percent of the original $10,000 investment. A change in the tax treatment of mutual funds would have a beneficial impact on all owners of mutual funds, but the benefits would primarily help those making less than $100,000 a year - 81% of households owning mutual funds, with 39% of households owning mutual funds earning less than $50,000 a year. A deferral mechanism, as proposed under H.R. 168, is relatively simple and would not result in a significant paperwork burden for mutual funds or their shareholders.