This year's capital gains payouts are expected to be the largest since the boom of the late 1990s, and while that's good news for the mutual fund industry and the 39 million U.S. households that invest in them, it's increasingly unclear whether legislation currently pending in Congress will provide any relief from what could be a shocker of a tax bill.

It's unlikely that investors will benefit this year from the GROWTH Act, a bill now on the House of Representatives and Senate floors that would exempt investors from taxation on capital gains if they automatically reinvest. And while optimism for the bill was high just months ago, a growing national deficit, the war on terror and hurricane relief efforts are draining the government's revenue streams and placing the GROWTH Act's future in jeopardy.

But the good news, according to Brian Reid, chief economist at the Investment Company Institute in Washington, is that capital gains on taxable accounts this year should improve on last year's $22 billion, which was up from a modest $6 billion in 2003 and $5 billion in 2002.

"Given that we've seen some strength overall in foreign equities markets and some strength in sub-sectors like natural resources, and that the market relative to a year ago is up a fair bit, I would expect the gains to be a bit higher than last year," Reid said.

Fund firms are currently notifying shareholders about distribution estimates for the period beginning Nov. 1, 2004, and ending Oct. 31, 2005. Checks are mailed in December. About $4.9 trillion of the industry's $8.2 trillion under management resides in taxable equity fund accounts.

T. Rowe Price has already indicated that retail equity fund gains should improve by 35% to 40% versus 2004. Fidelity Investments said the stock market environment of 2005 makes it likely that their investors will realize improved gains, too. Vanguard Group also expects improvements.

Running contrary to those gains, however, are rusty tax laws that, critics say, unfairly clip those households that choose to reinvest capital gains. Unlike capital gains on directly held stocks, where investors are taxed only when they redeem their shares, capital gains on mutual funds are taxed every year, regardless of whether the investor keeps the money or reinvests.

Last year, the tax bill to investors was roughly $9.6 billion, according to Tom Roseen, a senior research analyst at Lipper of New York. "That was also a very, very conservative estimate," he said. It should also be noted that a 15% cap on long-term capital gains and corporate dividends that was instituted in 2003 and expires in 2008, helped keep the 2004 tax bill from going even higher.

Over the last 10 years, according to Roseen, taxable mutual fund investors have surrendered on average of 20% to 30% of their load-adjusted returns to Uncle Sam. In 2000 alone, taxable fund investors surrendered $31.3 billion. And with capital gains distributions kicking into high gear this year, he expects that tax drag to return.

"As we go forward and returns begin to moderate back to the mean - 8%, 9%, 10% per year with 2% to 3% slowed by taxes - we're looking at a real drag on performance," he said.

One reason the tax bill might be particularly high this year, Roseen offered, is that most portfolio managers have eaten through the losses they incurred during the bear market. But whether it's enough to compel investors to pressure lawmakers for fairer tax treatment, he added, remains to be seen. Roseen recalled 1999 and 2000, years when 40% returns took the sting out of capital gains taxes. It wasn't until the following year, when the sell-off occurred and investors were hit with a double-whammy - losses in their mutual fund and a big tax bill - that there was significant outcry. That's when it would have prudent to push through a reform like the GROWTH Act, he said.

"The government wouldn't have been impacted quite as much. Now, I'm not real optimistic," Roseen said.

Getting the word out about the GROWTH Act might make the difference.

According to American Century Investments, a $100 billion investment manager in Kansas City, Mo., nearly half of all Americans support legislation like the GROWTH Act. The firm recently surveyed 1,007 Americans and nearly one out of two respondents said that Congress should pass the act. Among those with taxable and tax-deferred fund accounts, 65% said they would support the legislation. Among the survey participants who don't own mutual funds, a surprising 38% said they, too, would support the change.

"There is significant public support for Congress to modify the tax code," said Bill Bates, vice president of government affairs at American Century. "In addition to being sound public policy, this legislation fixes a quirk in the tax code that currently puts taxable mutual fund accounts on unequal footing with individual securities."

"This legislation has been somewhat overshadowed by more controversial retirement security proposals,"he added.

The ICI, meanwhile, has launched a new Web site, www.fundingyourfuture.org, promoting the act. The site includes extensive, simplified data on the impact the legislation might have on long-term savings and first-person endorsements by investors hoping to wring more out of their savings.

According to Kate Matus, press secretary for one of the GROWTH Act's original co-sponsors, Rep. Paul Ryan (R-Wis.), the bill is pending before the House Ways & Means Committee. Ryan recently circulated a letter among his colleagues to gain further sponsors. The letter noted, among other things, the increasingly important role mutual funds have played as a supplement to Americans' retirement savings.

Alison Aikley, a spokeswoman for the bill's co-sponsor in the Senate, Sen. Michael Crapo (R-Ind.), said last week that he and his staff are also working on getting co-sponsors.

While there's no question that long-term investors will gain from passage of the GROWTH Act, it's a little harder to quantify the benefit that money management firms might enjoy. After all, critics might argue, mutual fund firms already offer products, including IRAs and 401(k)s, that aren't taxed on an annual basis. Tax-efficient index funds have also been around for many years, and the recent emergence of exchange-traded funds provides another alternative for investors.

"Ultimately what's good for the investors is good for the funds," Reid of the ICI said. "If people are accumulating more assets and are saving, that's good for the industry."

It would also take a key decision-making process off the shoulders of the fund manager, who is tasked with allocating money for both taxable and tax-deferred investors, and place it with the investor, who would decide whether to collect the gains or reinvest.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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