For decades, mutual fund investors have had a big chip on their shoulders. Yet only now, after one of the worst declines in the history of the stock market has almost made it a moot point, are policymakers starting to take a close look at getting rid of perhaps the biggest disadvantage fund investors ever deal with.

The tax hassle of funds
Mutual funds have a problem with capital gains. In order to qualify as a mutual fund for tax purposes, a fund has to distribute all of its dividend and capital gains income to fund shareholders on an annual basis. Shareholders are then required to declare those distributions as income on their tax returns.

On the surface, that seems completely reasonable. After all, the fund usually doesn't get taxed as a separate entity, so someone should have to pay the taxes that the fund incurs. And like partnerships and certain other business entities, spreading the tax liability around in proportion to the number of shares each fund owner holds seems like an equitable way to do it.

An easy solution?
The problem, though, is that many mutual fund shareholders never actually see the cash from those distributions. If you simply reinvest that money to buy more shares of your fund, then you have to pay whatever taxes you end up owing with money from somewhere else.

What makes that seem particularly harsh? Because those distributions are paid directly from fund assets, reinvesting them is the only way to keep your fund investment whole. For instance, say you have $1,100 invested in 100 shares of a mutual fund worth $11 per share, and the fund pays a $1-per-share distribution. After the distribution, the fund's value will go down to $10 per share. If you take your distribution in cash, you'll get $100, but your fund shares will only be worth $1,000. Only by reinvesting that $100 into 10 new shares will you maintain your $1,100 investment.

Some people think that's reason enough not to force shareholders to pay tax on capital gain distributions. Recently, Harvard Professor John Coates and the Committee on Capital Markets Regulation proposed several changes to make the U.S. mutual fund industry more equitable to taxpayers and more competitive with funds available abroad, many of which don't bear the same tax liability that U.S. funds do.

A case of bad timing
Allowing investors to defer capital gains tax would be a definite advantage for fund shareholders in the long run. But where were these experts when shareholders actually had gains on which to pay taxes?

Right now, many mutual funds have huge accumulated losses from rotten investments that should allow them to avoid making taxable gains distributions to investors for quite a while. In particular, Vanguard gives very detailed information on accumulated losses:


Accumulated Losses As % of Share Price (Realized / Unrealized)

Holdings With Losses Likely Include ...

Vanguard REIT Index Fund (VGSIX)

(11%) / (60.3%)

Equity Residential (NYSE:EQR), Simon Property Group (NYSE:SPG)

Vanguard International Growth (VWIGX)

(24.7%) / (9.6%)

Nokia (NYSE:NOK), Arcelor Mittal (NYSE:MT)

Vanguard Total Stock Market Index Fund (VTSMX)

(4.7%) / (22%)

Bank of America (NYSE:BAC), Pfizer (NYSE:PFE)

Vanguard Growth Equity (VGEQX)

(130.9%) / (9.4%)

Walgreen (NYSE:WAG), Progressive

Source: Vanguard, Morningstar.

As you can see, it would take a massive rise in the value of these funds -- combined with the funds' deciding to cash in their investments to generate realized gains -- before shareholders will need to worry about receiving any potential taxable gains distributions.

A painless fix
Still, policymakers do have one thing going for them. Because shareholders won't be paying tax on their fund gains anytime soon, changing how funds get taxed won't sacrifice any current government revenue. With the federal budget as tight as it already is, maybe that means these proposals are well-timed after all. Regardless, making the change would certainly boost the future prospects for fund shareholders, who are still reeling from bear-market losses.

Do fund investors deserve a tax break? Sound off in the comment box below.

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Fool contributor Dan Caplinger always loves a tax break. He owns shares of ArcelorMittal and Vanguard International Growth. Nokia and Pfizer are Motley Fool Inside Value selections. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is always right on time.