What they are, when they come, and how to keep them to a minimum.
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By Marta Norton | 11-20-07 | 06:00 AM | Email Article

We all know it, but it's easy to forget: Money earned from mutual funds isn't free. As is true for any other source of income, Uncle Sam gets his cut. Mutual fund investors should be particularly attuned to taxes as the year winds down because that's when funds typically pay out capital gains to shareholders. In this article, we'll tell you what you need to know about mutual funds and capital gains, as well as steps you might consider taking to minimize them.

Marta Norton, CFA, is an investment manager with Morningstar Investment Management.

Defining Capital Gains
Fund investors have to pay taxes on their mutual funds in a variety of different scenarios. (Note: The following applies only to investors in taxable accounts. Investors in tax-sheltered accounts, such as IRAs and 401(k)s, generally receive much more favorable tax treatment.) If a bond fund makes regular income payments or a stock fund pays dividends, you have to pay taxes on those payouts. You also have to pay taxes if you sell a fund and the fund has appreciated in value over the time you owned it; that's called a capital gain.

Funds themselves incur capital gains. When a fund manager sells securities, the fund has a capital gain or a capital loss, depending on whether the security rose or fell in value while the fund owned it. A capital gain doesn't automatically mean a tax bill for the investors. If a manager also has a capital loss, he or she can use the loss to wipe out the gain (and the corresponding tax bill). The offsetting losses don't have to be in the current year. Mutual funds can keep capital losses on the books for seven years and use them to opportunistically erase gains (capital losses from previous years are called tax-loss carryforwards). If a manager doesn't offset the current year's gains with losses, the mutual fund must pass along the gains to shareholders by the end of the accounting year. All taxable investors, even those who automatically reinvest the gains in the mutual fund, then have a date with the tax collector. Capital gains distributions for most investors are taxed at a 15% tax rate, although capital gains classified as short-term gains, or gains from securities held less than a year, are taxed at the higher ordinary income tax rate.

When You Get Them
Mutual funds typically distribute capital gains in November and December. For those wanting a heads up, capital gains estimates are usually available on companies' Web sites in the fall. Investors can also call fund companies and ask about the year's upcoming distributions. However, should a fund company remain tight-lipped, investors can still get an idea of what's coming by doing a bit of homework. Take a look at your fund's portfolio manager. If the fund has changed hands over the course of the year, there's a good chance a tax bill could be headed your way, because new portfolio managers often remake portfolios to fit new approaches. Similarly, if a fund has tweaked its strategy over the past year, its manager could have sold more securities than usual. Funds that have faced lots of redemptions in the current year could also have painful capital gains distributions coming, because the funds may have had to sell securities to cash investors out. For example, because of a rush of redemptions, the successful--and historically tax efficient-- Muhlenkamp Fund  estimates a 2007 capital gains distribution equal to at least 10% of its net asset value. Finally, high-turnover funds often face capital gains distributions, because they are frequently buying and selling stocks. Distributions at these funds can be even more painful than usual, because the funds' short time horizon may mean that they sell securities that generate lots of higher-taxed short-term capital gains.

How to Avoid Them (Well, At Least Minimize Them)
It's tough to get by scot-free on capital gains taxes, but there are a few things that investors can do to minimize the pain. First and foremost: Double-check to ensure that the fund you're interested in buying doesn't have an upcoming capital gains distribution. If you don't, you could end up paying capital gains taxes on gains you didn't get. Second, make sure you put tax-inefficient funds, including the churners and burners discussed above, in a tax-deferred account, such as a 401(k) or IRA. If tax-deferred accounts aren't available, investors can instead opt for extremely low turnover funds, such as large-blend offering  Selected American Shares . Not only are these funds more tax-efficient, they often have a better chance of earning higher returns because they keep transaction costs, or costs incurred from buying and selling securities, to a minimum. Finally, investors can choose tax-managed funds, such as  Vanguard Tax-Managed Appreciation , which aims to avoid capital gains distributions altogether. (Find out a bit more about tax-conscious offerings here.)

A Word Of Caution
No one likes paying taxes and it makes sense to be cognizant of when capital gains distributions are coming and how to minimize them. However, we'd caution investors not to get too hung up on finding the most tax-efficient option available at the expense of maximizing total return. After all, the goal should be to take the most total return home after taxes, not minimize the taxes on a mediocre performer. Thus, we encourage investors to make finding superior funds the paramount goal. The efforts at tax efficiency can come next. 

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Marta Norton does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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