TOPSHOT – The dome of the US Capitol is seen at dusk in Washington, DC on November 13, 2023. (Photo … More
While there’s no evidence that Albert Einstein uttered the quip long associated with him about compound returns as the “8th Wonder of the World,” it’s not unreasonable to imagine the genius wit saying something just like that. When it comes to savings, compounding has wondrous qualities that become magical over time.
That’s why the patient investor can combine prudence with time to become a well-to-do retiree. As investor Barry Ritholtz pointed out in his recently released book How Not To Invest, compounding easily papers over a multitude of investment errors, including a propensity to buy at the top of every market. What Ritholtz found via empirical study is that over long stretches of time, the returns enjoyed by the investor prone to buy just ahead of market declines and corrections does almost as well as the proverbial unicorn who routinely buys at market lows. Such is the genius of buying and holding through market downs and ups.
These truths rate prominent thought in consideration of how capital gains achieved by mutual funds are presently taxed. While the funds themselves don’t pay taxes on gains realized through sales, the individual investors in their funds do. That’s the why behind the title of this opinion piece.
Even when mutual fund investors intend to hold their shares in the fund for the long-term, they pay annual capital gains taxes as though they’re actively trading. Explained more plainly, gains realized by the fund managers are paid for in taxes by the smaller, frequently retail investors in the fund. Stop and think about this.
On its face, the tax shifting that this enables exists as a penalty placed on small investors who wisely outsource their stock-picking to others. Outsourcing is crucial precisely because investing is best left to the experts. To invest for oneself is like cutting one’s own hair.
At the same time, what are investors supposed to do when doing the right thing comes at a cost? Compounding once again reveals magical qualities when matched with time, but if the returns are going to be compromised by taxable event-style trading that is paid for by the retail investor, then the incentive is to still buy and hold, albeit in cutting one’s own hair fashion.
Thankfully there’s a potential fix working its way through Congress. Reps. Beth Van Duyne (R-TX) and Terri Sewell (D-AL) have introduced the Generating Retirement Ownership Through Long-Term Holding (GROWTH) Act to correct what saps the genius of patient, buy-and-hold retirement saving. The GROWTH Act will spare buy-and-hold mutual fund investors annual taxes run up by fund managers, and will instead defer the taxation on realized gains to when the retail investor ultimately sells the shares in the fund. So, while there shouldn’t be taxation of any kind on capital gains, the GROWTH Act at the very least corrects a retirement-sapping injustice that neuters the genius of compounding through annual taxation gains realized by fund managers, as opposed to fund shareholders.
Enormous effort goes into planning for and saving for retirement. What a mistake to penalize prudence with a tax levied on retirement savers acting with extraordinary prudence. Let’s erase a very real bug in the tax code that so substantially chips away at the genius of patient, long-term retirement saving.
