Both candidates, listen up: This is the right thing to do

Dear Sens. McCain and Obama,

I'm writing on behalf of fund investors everywhere, the kind of average consumers you are counting on to prop up the economy, the type of investors you are asking to stay patient and stay put with the markets, and the taxpayers who are footing the bill for the foolishness that has put the credit markets on the brink of disaster.

We're living through horrible economic times and a miserable stock market, and we're about to get slapped again. It's not the next collapse -- the one that will soon force the next rescue plan -- it's the ordinary tax system kicking us in the fanny for our troubles.

More than 90 percent of all mutual funds have lost money this year, according to the researchers at Morningstar Inc. As fund managers have been flailing to stay afloat, they have been trading like crazy, generating capital gains and, in turn, creating a tax liability for investors.

Clearly, there's the potential for 2008 to be the worst year ever for fund distributions; the only hope is that the record $1 trillion that Lipper Inc. calculated as being paid out last year and the $900 million paid out in 2006 shook out enough long-term gains so that the problem has started to exhaust itself.

Still, at a time when fund investors are increasingly anxious to leave the market, taking the risk that it "might not be so bad this year" is foolish. Especially when you can fix the problem.

And that's why I am writing, to push for that solution. Here's how and why the problem hits home.

Mutual funds are "pass-through" securities, meaning that tax obligations pass through the fund and on to shareholders, who are on the hook for their share of taxes due. So when a fund manager trades securities or locks in profits, any paper gains create real tax liabilities; as a result, an investor who holds a fund in a taxable account can get slugged with a heavy tax bill, even in a year when the fund has lost money.

Shareholders must pay the tariff even if they never touch the distribution and simply reinvest the payout.

Based on Lipper's numbers of distributions, in each of the last two years more than $1 out of every $25 invested in funds has been recycled, passed to the shareholder as a recognized gain and, in most cases, reinvested in the fund, to create a potential tax liability along the way.

The problem is not with taxing gains, it's the idea that so many people will pay taxes on "gains" again this year when what their fund account is showing them is actual losses.

Here's where you come in. For the past few years, bipartisan legislation has been stalled in Congress that would change the way funds are taxed and end this distribution problem. Best of all, over time the plan is revenue-neutral -- it eases the burden on investors now but brings in the same revenues over time -- meaning you both can support it, claim it as a middle-class tax cut and know that it's not going to create additional tax burdens elsewhere over time.

Don't pork it up, don't let party politics bog it down, just get it done, and prove to the little guys that your caring talk is more than just rhetoric.

Sincerely, Chuck Jaffe

Senior Columnist, MarketWatch
Charles A. Jaffe is senior columnist at MarketWatch. He can be reached at or at Box 70, Cohasset, MA 02025-0070.