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Taxation of Mutual Fund Shareholders
Under current law, mutual fund shareholders are taxed on a fund’s distributions of income and gains, regardless of whether the distributions are received in cash or reinvested in additional fund shares. Taxable distributions may be “ordinary income” (attributable to certain dividends, interest, and short-term capital gains), “qualified dividend income” (taxable at a 15% maximum rate), or “capital gain dividends” (distributions of long-term gains taxable at a 15% maximum rate). Shareholders receive “cost basis” for the full amount of any distribution reinvested in additional fund shares, meaning the distribution is added to the initial purchase price for tax purposes.
Shareholders also are taxed on any gains from the sale of fund shares—that is, on the excess of the sales proceeds over cost basis. Cost basis includes the amount paid for fund shares, including commissions, and the full amount of any distribution reinvested in additional fund shares.
Growth Act Taxation of Fund Shareholders
The Growth Act would defer the tax on reinvested capital gain dividends (i.e., long-term capital gains) until shares in the fund are sold or transferred. Thus, the taxation of fund distributions under current law and the Growth Act would be similar in most respects. Distributions of ordinary income and qualified dividend income would remain taxable currently (whether the distributions are received in cash or reinvested in additional fund shares). Shareholders would receive cost basis for the full amount of reinvested distributions—including shares acquired with reinvested capital gains on which tax is deferred.
The current law rules for calculating gain or loss on the sale of fund shares likewise would be unchanged. Gain or loss still would be determined based upon the difference between sales proceeds and cost basis.
The deferred gain would be taxed at the time of sale or other transfer of fund shares (including death) through “proportionate recapture.” Thus, for example, if a shareholder who had deferred tax on $10,000 of reinvested capital gain dividends redeemed half of his or her fund shares, half of the deferred gain ($5,000) would be included in taxable income as a long-term gain.
Comparison to Taxation in Other Countries
Mutual fund investors are taxed in different ways around the world. Many countries (particularly in Europe) neither require funds to distribute their income and gains nor tax retained amounts. These funds are known as “roll-up” funds. Many countries also exempt some or all capital gains from tax.
Thus, the Internal Revenue Code currently imposes a significantly higher tax burden on mutual fund investing than is imposed by many foreign countries. The Growth Act would reduce somewhat this impediment to savings.
EXAMPLEA mutual fund shareholder invests $10,000 in a fund on January 1 in Year 1. Every year for 10 years, the shareholder receives an ordinary dividend of $100 and a capital gain dividend of $300; these dividends are reinvested automatically in new shares. In addition, every year for 10 years, the shareholder’s account grows to reflect $200 of unrealized gains. Thus, at the end of 10 years, the shares are worth $16,000 ($10,000 initial investment, $1,000 of shares acquired with reinvested ordinary dividends, $3,000 of shares acquired with reinvested capital gain dividends, and $2,000 of unrealized gains). The shareholder redeems the account on January 1 of Year 11.
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Current Law Taxation
In the example above, every year the shareholder is taxed on $100 of ordinary dividends and $300 of capital gain dividends. The shareholder gets cost basis of $400 each year for the shares acquired with the reinvested dividends.
On January 1, Year 11, the shareholder sells the shares for $16,000 and reports a $2,000 capital gain, which is the excess of the sales proceeds over the cost basis ($10,000 plus $4,000).
Growth Act Taxation
Every year, the shareholder is taxed on $100 of ordinary dividends. No current tax is imposed on the $300 capital gain dividend that is reinvested each year; this gain is deferred. The shareholder gets cost basis of $400 each year for the shares acquired with the reinvested dividends.
On January 1, Year 11, the shareholder sells the shares for $16,000 and reports a $2,000 capital gain, which is the excess of the sales proceeds over the cost basis ($10,000 plus $4,000). The shareholder also reports the deferred gain ($3,000).
Comparison
Under both current law and the Growth Act, the shareholder is taxed currently on the ordinary dividends (totaling $1,000 over 10 years). In both cases, the shareholder also is taxed on capital gains totaling $5,000. The difference is that $3,000 of the gain is taxed over the course of the investment ($300 per year) under current law, whereas all $5,000 of the gain is taxed when the investment is sold in Year 11 under the Growth Act.
