Adding insult to injury.

Kicking a guy while he’s down.

Leveling capital gains distribution taxes on mutual fund owners this year.

They’re all peas in a hateful pod.

You’d think that the surest way of avoiding a capital gains tax liability would be not having any freaking capital gains.  Hey, that makes sense.  Even the sneakiest IRS creep can’t come up with a way to tax you for losing, right?

Not so fast.  We’re talking about taxes.  Your logic has no place here.  There are thousands of Americans who, after losing as much as 40% on mutual fund investments, will be stuck with an additional tax liability on top of that devaluation.

How does that happen?  It’s called a distribution.  Gail Marks-Jarvis summarizes the situation:

Because investors are becoming discouraged about their losses, mutual fund managers are being forced to sell some of their best stocks to raise cash for the investors who are fleeing. That means the mutual fund incurs a capital gain on profitable sales of stock. Under federal law, those gains, plus dividends, must be passed on to the people who have money in the mutual funds. They are called “distributions,” and must be reported on tax returns.

Basically, if your fund bought one of its many stocks at $5 years ago and sold it recently for $15, you’re going to be on the hook for some of the capital gains tax liability associated with that sale.  The fact that the stock was worth $30 last year is a moot point.  The fact that every other stock in the portfolio may have lost money this year?  Also unimportant with respect to this particular element of the tax code.

This can translate into some serious coin, too.  Consumer Reports explains how some of the biggest losers among mutual funds this year are still on the hook for big capital gains taxes:

But some funds will pay out huge. Vanguard Precious Metals and Mining (VGPMX), for instance, has lost 64 percent of its value so far this year, but will send out long-term capital gains distributions equal to about 15 percent of its share price. T. Rowe Price Spectrum Growth (PRSGX), which is down 43 percent year-to-date, is expected to pay out 9 percent of the fund in taxable distributions.

Most of us will shake our heads in dismay at the idea of taxing someone for capital gains after they barely survived the biggest stock market freefall we’ve seen since folks were living in Hoovervilles.  Luckily, we’ll probably avoid the tax liability, though.

If your mutual fund investments are in a 401k wrapper or are part of an IRA, you won’t have to worry about the distribution.  You can be sickened by the dementedness of it all, but at least you won’t be compelled to pay capital gain taxes on positions that lost money.  Only those who have made mutual fund investments outside of the tax-protected account types will get stuck ponying up for the distributions.

This approach to kicking a guy while he’s already down has been the subject of criticism even before this year’s weird state of affairs.  Bruce Bartlett railed against the distribution approach while providing an alternative back in 2000, writing on the National Center for Policy Analysis site:

Obviously, a simple way of relieving taxpayers would be to treat mutual funds the same way that individual stocks are treated for tax purposes. Mutual fund investors would only be liable for capital gains taxes when they sell their mutual fund shares. Reinvested gains would be treated as unrealized gains for tax purposes.

Now that investors will be paying distributions for accounts that lost a great deal of value, it might be time to investigate options like the one posited by Bartlett.  There must be a better way to handle the taxation of mutual funds than rubbing salt into open wounds.