Most mutual fund investors have smiled at their quarterly statements for years now. But new villains, scarier than any costume-clad Halloween tricksters, are coming soon to a mutual fund near you: Uncle Sam and the IRS.

Stock mutual funds have turned in a great performance since the last bear market ended in 2002. Since then, many mutual funds have been able to use their losses from the tech bubble to offset current gains from trading in their portfolios. After several years of gains, however, most of those funds have run out of offsetting losses, leaving them no alternative but to pass their accumulations on to investors in the form of capital gains distributions. You'll typically get these distributions in the last half of December.

What, me worry?
Your first thought may be that this doesn't affect you. If you have these distributions reinvested in new fund shares, then you'll never receive a check, and your shares after the distribution will be worth exactly what they were before it.

But that doesn't mean you won't be taxed. Even if you don't take your capital gains distributions in cash, they'll still show up on your 1099 tax forms in January. Not reporting that income is a serious mistake.

That means that quite a few investors could get an unexpected tax bill come next April, and the early indications suggest that those gains could be considerable. According to Money Magazine, a fund analyst at Lipper research believes that total taxable distributions could exceed last year's figure of $24 billion.

No big surprise
Even if they have to deal with taxes, investors can at least point to good returns. Vanguard's Windsor II Fund, for instance, has increased its net asset value by more than 9.5% this year, but it's also up more than 9% year to date. Some of those gains may have come from the fund's sale of part of its stakes in Verizon (NYSE:VZ), Honeywell (NYSE:HON), and Exelon (NYSE:EXC), each of which has risen significantly in 2007.

Similarly, Vanguard's International Growth Fund will distribute almost 7% of its assets for capital gains, resulting in part from reductions in its positions of highfliers like Rio Tinto (NYSE:RTP) and Petroleo Brasileiro (NYSE:PBR).

Who should worry
Not all investors need to be concerned about fund distributions. For instance, if you hold fund shares in an IRA or employer plan, you won't pay any taxes -- all income in those retirement accounts is tax-deferred until you start taking distributions.

If you have mutual funds in taxable accounts, however, you'll pay tax. Yet you can still take steps to reduce your pain:

  • Don't buy in. If your fund expects to pay a big distribution, now's not the time to make new investments. For those with automatic investment plans, where you transfer $50 or $100 each month from your bank account to buy shares, making changes probably isn't worth the trouble. But if you've been thinking about making a big one-time investment, hold off until after the fund makes its distribution.
  • Don't sell out (usually). You might be tempted to dump your shares in the hopes of avoiding those taxes. But bear in mind that selling your shares would likely incur even more capital gains. If you've held fund shares long enough to have enjoyed a big run-up, you'll usually be better off if you don't sell.

For fund investors, paying tax will be a nasty trick. But at least you've gotten the treat of nice returns over the past several years.

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