It's bad enough you've lost so much money on your investments. But paying taxes on gains that have long since evaporated is even worse.

As the end of October approaches, so too does the end of the fiscal year for many mutual funds. Some fund companies have already started announcing estimated year-end distributions of capital gains. The most surprising thing is that these funds actually have any gains to distribute -- especially after the big losses they've suffered in recent months.

Phantom gains
Among those funds announcing gains are some with huge losses. For instance, the ING Financial Services Fund (PBTAX) is down 42.7% for the year, thanks to substantial holdings in Bank of America (NYSE:BAC) and AIG (NYSE:AIG).

Similarly, ING's Mid-Cap Opportunities Fund (NMCAX) is off 43.4%, as bets on XTO Energy (NYSE:XTO) and Weatherford (NYSE:WFT) haven't paid off for the fund. Although the distributions aren't huge -- about a dime per share, or roughly 1% of net asset value -- they'll still be tough for investors to swallow after losing so much of their principal.

But not all distributions will be that small. The Investment Company of America (AIVSX) fund from American Funds expects to pay between 2% and 4% in capital gains. Even its blue-chip holdings, which include AT&T (NYSE:T), Schlumberger (NYSE:SLB), and ConocoPhillips (NYSE:COP), haven't saved it from a 39% loss in 2008.

Why gains come from losses
How can funds down 40% or more force shareholders to pay taxes on capital gains? In one sense, the answer comes from the way the tax laws treat mutual funds. Funds are required to pass through any gains to their shareholders. In return, fund shareholders don't suffer the double taxation that would otherwise apply -- taxed once at the fund level, and then again for shareholders.

Yet fund managers can't dodge responsibility entirely for their funds' tax liabilities. The investment decisions that managers make have everything to do with whether shareholders have to pay tax or not. In response to the panic, many fund managers have had to deal with shareholder redemptions.

Because fund shareholders have the right to sell at any time, fund managers sometimes have to raise cash quickly in order to meet distribution requests. In tough markets like this one, that can lead fund managers to sell stocks they've held for years, despite the tax impact that selling long-term winners has on investors who hang onto their shares.

Relief coming?
For years, Congressional legislators have considered giving mutual fund shareholders a break on capital gains taxes. Since many investors automatically reinvest their distributions back into the fund in exchange for more shares, shareholders have a good argument that they shouldn't have to pay capital gains taxes until they actually sell their shares.

Unfortunately, ballooning budget deficits and the costs of the many government bailout packages we've seen so far during the financial crisis make it increasingly unlikely that investors will get capital gains breaks in the near future. By next year, the issue will likely be moot, as fund managers and shareholders alike will have losses on many of their holdings.

Be ready
As part of your year-end tax planning, planning for fund distributions is a key element. Here are some quick tips:

  • Know what's coming. Most fund companies are good about releasing distribution estimates early enough for you to plan for them.
  • Don't buy the distribution. If you're investing in a taxable account, put off buying fund shares until after the fund pays out capital gains. That way, you won't get hit with an immediate bill.
  • Buy in IRAs. Tax-deferred accounts shield you from tax liability from distributions, so consider making purchases in them.

Paying taxes on gains in one of the worst years in history for the stock market is just one more example of how the tax laws sometimes make no sense. Ideally, that law will change soon. But until then, you can still avoid at least some of the added tax bill from capital gains distributions by being prepared.

For more on investing in today's markets, read about:

If your mutual funds have you down, you need better funds. Our Motley Fool Champion Funds service may be just the ticket, with monthly recommendations of funds that have performed well in good times and bad. Take a look free with a 30-day trial and see how Champion Funds can help you become a better investor.

Fool contributor Dan Caplinger expects to pay some taxes on losing funds this year. He doesn't own shares of the companies mentioned in this article. Bank of America is a Motley Fool Income Investor pick. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you the good news.