Picture it: You find a wonderful mutual fund. It's got a great track record, a manager whose thinking you admire, low fees, relatively low turnover, and holdings in the category you're most interested in (perhaps large-cap stocks, energy stocks, or Panamanian-show-dog stocks). You're eager to invest in it. There's no reason not to, right?

Well, actually, there is: the nightmare of capital gains taxes.

Yes, every year around this time, mutual funds have to pass along gains to their shareholders. That makes it undesirable to invest in many funds at this time of year.

For one thing, when a capital gains distribution is made, the fund's value is adjusted downward accordingly. If you buy just before the distribution, you'll face taxes on an investment you didn't own for very long -- and in many cases, one you never owned. Funds often wait nearly the entire year before paying out gains from a sale early in the year.

Confusion time
This confuses many investors. Last year on our Mutual Funds discussion board, many folks were puzzled when their funds seemed to crash suddenly, without explanation. Many dropped by several dollars per share, representing a significant percentage of assets. That can make shareholders panic. This year I expect to see similar queries.

Bear in mind, though, that you haven't really lost money. Those distributions get paid back to you, either in cash or in the form of more shares. But that doesn't make it any easier to deal with the tax hit.

Managing these matters
Of course, there are sensible ways to deal with this situation. For example:

  • Invest in funds inside a tax-advantaged account, such as an IRA or 401(k). Such accounts are great places for your least tax-efficient investments. (Learn more in our IRA Center or our 401(k) nook.)
  • Reinvest your distributions to ensure your account balance won't suddenly fall. It's also a great way to build wealth. (Of course, if you take the cash, you can always use it to buy into another compelling investment -- just keep investing with it instead of spending it on something you don't really need.)
  • Do some research. Some funds are better about taxes than others. At sites such as Morningstar.com, you can look up the tax efficiency of various mutual funds. In some cases, a fund that looks impressive before taxes doesn't perform nearly as well once you take taxes into account. Seek out tax-efficient mutual funds, and you'll reduce the distribution tax hit.
  • Consider investing in exchange-traded funds (ETFs) to some degree instead of traditional mutual funds. Certain ETFs essentially mimic many index funds, for example. And with ETFs, you control when you realize gains by when you sell your holding.
  • Call a fund company before you invest in it, and ask when it will pay its capital gains distribution and how hefty it's expected to be.

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