The IRS Kicks You When You're Down

Mutual funds are where most of us working stiffs invest our money. And there are lots of good reasons why we do it -- they're run by professional money managers (of course, "professional" doesn't necessarily mean "successful"), they offer broad diversification (usually), and they charge low fees (sometimes).

But the biggest drawback to mutual funds is their legal structure as "pass-through entities." That's legal BS meaning any "tax liabilities incurred by the fund are passed on to the shareholders" -- that would be you and me. And by law, mutual funds must distribute 98% of dividends and capital gains they earn in a given calendar year.

All of which sounds okay -- or at least as okay as any tax law can sound. The problem is that you can be taxed even if your investment lost money (which has happened a lot over the last few years). If your fund sold some investments for a profit -- even if you never benefited from those profits -- those profits will be distributed to you and you'll be taxed on them. And you know that in a volatile year like this, portfolio managers do a lot of buying and selling and often take profits on long-term holdings to reallocate to new opportunities. The bad news is that you could have invested $10,000 in a fund that is now worth $7,500. The worse news is that you could very well receive a taxable distribution of $1,000 or more -- adding insult to the injury you've already suffered.

This is a ridiculous absurdity by any standard. Gains on mutual funds should be treated like individual stocks and taxed only when you sell and you actually reap the benefits of the gains. Paying taxes on unrealized "paper profits" is un-American. It's not Blue or Red -- it's a cowardly Yellow. Our fearless leaders in Congress have taken the right step in proposing to change the tax laws so you can defer gains until you sell - but they haven't been fearless enough to actually pass this type of legislation.

So take a moment to let your senator and congressman know that you don't appreciate being taken advantage of in such an egregious manner. Paying taxes on income is an acceptable pain in the butt. Paying taxes on non-income is criminal.

For more investing insights, please check out Your Nest Egg Game Plan: How To Get Your Finances Back On Track and Create a Lifetime Income Stream by Phil Fragasso and Prof. Craig Israelsen.