Monday, March 02, 2009

The lie of the day (UPDATE/CORRECTION) 
UPDATE/CORRECTION: Reader Dan points out an error I made in writing this post earlier. I thought of it, too, driving around today, but couldn't get back to a computer in time to amend.

The error is this: Taxable distributions represent capital gains to the fund, but are taxed as income to the fund shareholder, not as capital gains. If the Bush tax cuts expire, the point still stands, because Bush cut taxes for all income levels - not just the top brackets. Obama has stated that he supports limiting tax increases to those making over a certain amount. We'll see what actually gets passed and signed into law.

Original post follows, as written.


Obama would like to increase capital gains taxes on anyone making more than 250,000 dollars per year.

So who would that affect? ANYONE who holds mutual funds outside of a qualified plan.

That's not just going to screw the rich. That's going to hurt any diligent saver who invests excess capital in mutual funds.

Why? Because when a mutual fund sells a holding at a gain, that constitutes a taxable event, which they then pass on to shareholders in the form of taxable distributions. Mutual fund shareholders at all income levels are on the hook for this tax, and short of selling their shares (at a captal gain/loss), there is nothing they can do to avoid it, if they own the stocks at the time the distribution happens.

Once again, when Obama targets the rich, he winds up hurting the little guy. (News flash: The rich are in life insurance, annuities, and managed accounts, not mutual funds.)

To add insult to injury, if you bought into a mutual fund high, and the fund had redemptions going into the bear market of the last year, forcing it to sell stocks it had held for a long time, you could eat a taxable exemption, get handed a nasty tax bill, and have to pay taxes ON A FUND THAT LOST YOU MONEY!

Splash, out

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I'm not following your argument. The taxable distribution is taxed at my current marginal rate. (At least I think it is. All my mutual funds are in my 401k, so I could be wrong.) How does a hike in the capital gains taxes on those above 250K affect me?

You're correct, actually. Good catch. I was driving around this afternoon and that occurred to me but I hadn't gotten back home to type in the correction.

Where you would get hit is if the Bush tax cuts expire, since the Bush tax cuts applied to every bracket, not just the top one.

You could still get hit with a taxable distribution on a fund in which you lost money, though, at any tax bracket above zero, unless specific legislation is passed to exempt a certain amount of money from that tax. An attempt to do so was made around 2000 or 2001 by Republicans, but it failed, running into Democratic opposition.

But investors in Warburg Pincus's Japan Small Company fund got hit with a taxable distribution of over half of then NAV one year... in a year the fund lost money.


Why does this happen? If a bunch of people want to redeem shares, and the fund holds significantly appreciated shares, and doesn't have the cash reserves to meet the redemtions (Bogleheads HATE "cash drag"), then the fund is forced to sell securities in order to meet redemtions. For a while, they can match losers against winners to manage their tax consequences. But if the fund's been a winner in past years, they run out of losers to offset winners.

Then recent shareholders who pile in at the top of the market get to pay taxes on the accumulated gains for past shareholders who have long since bailed out of the fund.

(That's why I like redemption fees to keep short-term investors honest!)

My concern is that mutual funds have been hit with mass redemtions over the past year and a half, which would create the conditions for a rash of nasty taxable distributions, though I haven't been tracking it closely
Your point is valid, though, and thanks for pointing it out.

Well actually capital gains by the fund are reported as capital gains to the fund shareholder. Look on a 1099, you will see both income and capitol gains from most mutual funds.
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