The new tax plan has almost everyone on Wall Street giddy, with reason: It's largely a tax cut on investing. But mutual fund companies and their tens of millions of shareholders are excluded from the party. Certain provisions of the tax cut don't jibe well with the traditional mutual fund structure, and could make some types of mutual funds go the way of the dinosaur. For fund investors, investing just got a whole lot more complicated. Historically, stock dividends were taxed like bond payments, meaning they were taxed like ordinary income. Whether you received $100 in dividends from owning General Motors ( GM) common stock or $100 in coupon payments from owning bonds or even $100 in salary as a GM employee, you owed income tax on $100. Stock dividends will now be taxed at 15% for most investors, more akin to how long-term capital gains are taxed. While it's not the completely tax-exempt status the president wanted for dividends, this is a sharp drop in rates. The top long-term capital gains tax rate also was lowered to 15%. For those who receive dividends directly, the cut is a windfall. For those who own stocks indirectly through their mutual funds, the benefits are meager at best and a penalty at worst.
Why Funds Lose Out
Mutual funds incur expenses in the form of management fees, distribution charges and operating expenses from administrators, custodians, lawyers and accountants. For your typical fund, these fees add up to 1.4% per year. Mutual fund companies deduct these fees from the fund, but they charge them against any income the fund may receive from the stocks and bonds in the portfolio first. This makes perfect sense: Why take fees out of the fund's capital only to pass on a taxable dividend to the investor? If fees must be paid, then pay them in the most tax-favorable way.