Mutual funds have a nasty habit. Once or twice a year (usually in December), they distribute the capital gains they've been storing up for months. Shareholders of the fund receive the distributions, which are usually reinvested in the fund.

That sounds great, except those distributions don't increase the investors' net worth or the value of the investment. On the day of distribution, the net asset value (NAV) of the fund drops proportionate to the value of the distribution. So while shareholders who reinvest distributions will end up with more shares, the value of the investment stays the same.

And here's the real kicker: Shareholders will have to pay taxes on those distributions.

Also, the distributions are made to all shareholders, regardless of how long someone has been invested. Send your money to a mutual fund right before the distributions, and you'll have to pay taxes on growth you never saw. Which is why, at this time of year, mutual fund investors are advised to tread carefully before making a significant lump-sum investment.

If you're looking to minimize your fund-related tax hit, consider these strategies:

  • If you have a fund that is valued below your cost basis, you could sell your mutual fund for a loss, then buy back a similar fund. That way, you can claim the capital loss on your tax return but still be invested. While you can't do this with stocks without violating the "wash sale" rules, you can do this with mutual funds as long as you don't buy back the same fund or a fund that is substantially the same. (This presumes that the funds you sell and buy are no-load funds; otherwise, the tax savings probably won't be worthwhile.)

  • Call the mutual fund company before you invest and find out when distributions will be made. Distributions aren't just made in December, so always call the fund company before you invest.

  • You can avoid all these tax shenanigans by keeping mutual funds in Individual Retirement Arrangements (or "Accounts," depending on which IRS document you read).

Want more tips, picks, and strategies? Visit our Mutual Funds Center.