How Mutual Funds Could Get a Lot Less Taxing

focus on mutual fund investing
One hot-button tax issue that surprises many taxpayers every year is just how much tax their mutual funds can generate -- regardless of whether those funds have actually made their shareholders any money lately.

Recently, mutual-fund research giant Morningstar called on lawmakers to fix what many have long seen as an unfair tax law that hurts many fund investors. Although attempts by Congress over the past 15 years have thus far yielded no success, Morningstar hopes that the results of the 2014 elections will make compromise on this key issue for ordinary American investors more likely.

How Mutual Funds Hurt You at Tax Time

In general, mutual funds have a number of attractive characteristics. They allow investors with even small amounts of money to invest in a wide array of different stocks, bonds or other securities, with the ability to get a diversified portfolio easily and efficiently. Moreover, unlike regular companies, mutual funds don't have to pay any taxes at the corporate level, which means that they can pass through all of the income that they generate to their shareholders.

The price that mutual fund shareholders pay for these benefits, though, can be harsh. Mutual funds have to distribute nearly all of their income each year, including any capital gains that they've generated from the sale of investment securities in their portfolios. When you receive a mutual fund distribution, you usually have to include the distribution in your taxable income, unless you use a tax-favored retirement account like an IRA to invest in the fund.

Two aspects of mutual fund taxes are particularly unfair. First, you have to pay taxes on these fund distributions even if you never see the money. Many fund investors choose to reinvest any distributions back into additional fund shares, leaving them in exactly the same financial position before and after a fund makes its mandatory payout. Yet the Internal Revenue Service doesn't distinguish between receiving your distribution in cash or reinvesting it into the fund; you have to pay taxes either way.

What's even more unfair is that you might end up having to pay tax even if you never received the benefit from the income or capital gains in question. For instance, say you invest $100 to buy four shares of a mutual fund at $25 per share, the day before it makes a large capital-gains distribution of $5 per share. If you elect to have your distribution reinvested, you'll end up having a total of five shares, because your four shares will pay you a total of $20, exactly matching the after-distribution price of the fund shares: the original $25 less the $5-per-share distribution.

After you reinvest the distribution, those five shares at $20 each will still be worth a total of $100. Yet you'll have to pay tax on the $20 -- even though the gains came about from investments made long before you bought into the fund.

The History of Mutual Fund Tax Reform

Unfortunately, lawmakers have a bad track record in dealing with mutual fund tax issues. Back in 2001, when the bursting of the tech bubble led to huge losses combined with extensive capital-gains distributions from mutual funds, 90 mutual fund industry leaders looked for support in Congress to allow mutual fund shareholders to defer taxes on capital gains distributions. Yet the bill never moved forward.

On several occasions between then and now, the issue has arisen. Most notably, during 2008, the stock market again plunged at the same time that funds had to make sizable distributions. Yet the budget cost of offering that tax break is substantial enough that it's difficult for lawmakers to make the economics of the proposal work.

As a result, mutual fund investors shouldn't expect Congress to have their back at tax time. Alternatives that you have include using more tax-efficient exchange-traded funds, or investing with IRAs, 401(k)s, or other retirement accounts that offer tax deferral on mutual fund distributions. Unless lawmakers finally break through the gridlock to get mutual fund tax reform passed, your best bet is to take other measures to protect yourself from unfair taxes.

Motley Fool contributor Dan Caplinger has endured mutual-fund taxation for a long, long time. You can follow him on Twitter @DanCaplinger or on Google+. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.​

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