Investors are never happy.
On one hand, when the stock market is crashing and you're scared to open your brokerage statements, you complain that you'll never reach your financial goals because there's no way to make a buck in stocks. If you've forgotten what that's like, just think back to late 2002, when it seemed as though stock prices might never recover.
Yet even when the bull market is raging, as it has over the past four years, you can find something to complain about. This time, it's taxes. Investors in mutual funds started to see their year-end distributions of dividend and capital gain income rise dramatically in 2006, and with the S&P 500 starting to approach record highs once more, more increases are likely to follow.
There's a reason for the system, but there also are ways to keep your tax bill in check.
Heads the IRS wins, tails you lose
Many investors feel that the way the tax laws treat mutual funds are unfair. If you invest directly in individual stocks, you only have to pay current tax on any dividends they pay out. No matter how far the prices of your stocks rise, you don't have to pay capital gains taxes until you decide to sell your shares.
In contrast, mutual fund investors have to pay taxes on both dividends and capital gains even if they hold onto their shares for the long term. Because many fund managers buy and sell fund holdings on a continual basis, their funds recognize capital gain, and the tax laws require the funds to pass on the liability for those gains to their shareholders.
Obviously, investors would prefer not to have to pay any tax on capital gains until they sell their mutual fund shares. However, this would give fund investors an unfair advantage over those who trade individual stocks, and would encourage actively-managed fund companies to increase turnover within their funds. Funds could buy and sell shares at will, while individual investors would have to pay tax when they sold exactly the same shares, simply because they didn't hold them within a mutual fund.
What's fair?
Some people feel that the entire capital gains taxation system is flawed, as it encourages people to hold onto certain assets even when they might have better investment opportunities elsewhere. One proposed solution is to allow you to sell your investments on a tax-deferred basis as long as you reinvest the proceeds into other investments. Proponents point to similar laws that allow tax-free exchanges of real estate.
Of course, some people want to eliminate the capital gains tax entirely. Since corporations already pay tax on their earnings, they argue, it's only fair not to tax investors on their gains. Similar positions support not taxing investors on their dividend income.
Someone's gotta pay
The problem with all of these solutions is that they ignore the fact that the government needs revenue in order to function. Any tax system will have aspects that seem unfair. Even though many experts cite taxes on investment income and capital gains as one reason why the American savings rate is negative, the money investors earn on their investments is just as valuable as the money they take home in their paychecks.
Furthermore, changing the tax system to favor one type of investment over another can create unsustainable prices. It's not just coincidence that housing prices started to explode soon after Congress allowed homeowners to exclude up to $500,000 in gains from the sale of their homes, along with the earnings of homebuilders like D.R. Horton
Use index funds, avoid tax
In any event, fund investors have options that will minimize their taxes. Most index funds have only insignificant capital gains distributions. Because index components are relatively stable, index funds don't have to trade stocks frequently. Even if investors choose to sell their fund shares, most index funds use tax-lot tracking to identify the shares that will incur the least tax liability. You can also use index ETFs like the SPDR Trust
It's easy to complain about taxes. But it's far better to pay taxes on money you've earned than never to earn the money in the first place. So when you open up your next account statement, be happy if you've had good returns, even if you'll have to give a piece to the tax man next April.
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Fool contributor Dan Caplinger rarely complains about his taxes -- even now that he's self-employed. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't leave you complaining.
