The Tax Code Should Not Punish Mutual Fund Investors

Millions of Americans just got finished with the annual chore of filing their income taxes. According to the IRS, approximately 11 million tax returns reported capital gains distributed to them from mutual funds, even if the mutual fund owner didn’t sell any mutual fund shares or realize any gains. These “phantom” or “gotcha” capital gains are more than just an annual tax season irritant -- they discourage everyday, middle-class Americans from saving and investing for retirement, college, or even just a rainy day.

How do these phantom capital gains work? Around 122 million Americans own mutual funds, about $14 trillion of which are held in non-tax advantaged accounts. A mutual fund is a very common vehicle which can be thought of like an investment of other investments. A mutual fund might hold all the stocks in the S&P 500 index. It might own a mixture of stocks, bonds, real estate, and cash. It might hold just utility stocks. There are as many mutual funds as there are ideas about how to invest. It’s a way for an investor to shop in a bundle, instead of a la carte.

Unlike mutual funds held in 401(k) plans, IRAs, or 529 plans, mutual fund investments in taxable accounts owe taxes every year on capital gains income from trades generated within the mutual fund. Mutual funds are required to pass through these internal capital gains to the shareholder, even if an investor didn’t sell a single share of the mutual fund itself. It doesn’t matter if an investor never sees these dollars because they are reinvested in the mutual fund, as is almost always the case. On most other types of assets, the capital gains tax is not owed until an underlying asset is sold and a profit is received.

This nasty, “gotcha” surprise is often not discovered by the 37 million Americans who hold mutual funds in taxable accounts until they sit down to do their taxes. “But I didn’t sell anything” is the reaction tax preparers get, and it’s a common one. Sixty-six billion dollars in phantom capital gains are taxed every year, an average of $6,000 across 11 million “gotcha” households. The mere threat of complicated tax returns and a surprise tax bill discourages new savers and seniors alike from investing, at the cost of capital formation and savings in the markets. Meanwhile, it is also a loss for the real economy by diverting annual taxes on $66 billion to the IRS in your peak working and savings years -- money that could instead go to groceries, school supplies, repairs, or dining out.

Thankfully, there’s a bipartisan solution that’s been introduced. HR 2089, the “Generating Retirement Ownership Through Long Term Holding (GROWTH) Act,” co-sponsored by Representative Beth Van Duyne (R., Texas) and Terri Sewell (D., Ala.), would address this annual headache in a fair and balanced way and promote economic growth. Rather than having to pay taxes every year on capital gains distributed from inside the mutual fund, investors could defer those taxes until such time as they choose to sell shares of the mutual fund itself. Then and only then, when the sales choice has been made by the taxpayer herself, would a taxable event occur.

The bipartisan pedigree of the GROWTH Act is testament to what a commonsense idea it is. It’s rare for a Republican and a Democrat in the U.S. House’s tax-writing Ways and Means committee to come together on tax bills, especially in a tax environment this politically charged. But it’s not a partisan issue to encourage thrift and savings. There is no reason why the GROWTH Act should not be under consideration by congressional policymakers as they craft this year’s tax reform bill. It’s already been endorsed by Americans for Tax Reform.

The tax code should not be picking winners and losers depending on where you choose to hold your mutual fund savings. The same mutual fund that faces this phantom capital gains tax when held directly or in a brokerage account gets tax-deferred treatment in a 401(k), for example. In a 401(k), taxation of a mutual fund is deferred until a distribution is made from the account and shares are sold. The same thing should happen in any mutual fund investment account. The tax gets paid, but only when the investment is sold.

The GROWTH Act removes an irritant from our tax code which makes tax preparation difficult, and starting a lifetime habit of savings is easy to put off indefinitely. Encouraging good savings habits is a tax reform we should all be able to get behind.