How to Mimimize the Pain of a Fund's Capital Gains Distribution

Sometimes, your timing is bad and you buy a mutual fund near a peak.

Late in the year, you've got a paper loss on the investment. Yet your fund now is telling you you're going to get a taxable capital gains payment for the year--for "gains" you never benefited from.

Ouch. Ouch! Lousy returns and somebody else's tax bill. Now that's a double-whammy.

Welcome to the complicated world of mutual fund taxation.

In years past, when mutual funds were routinely racking up annual returns of 20%, 30% or more, the tax bite from capital gains payments may have annoyed investors, but at least they saw their investment advancing as well.

2000 and 2001 were different: Some of the hottest funds plunged--but they still made taxable capital gains distributions.

What are these fund distributions, who needs to be concerned about them, and what can you do to lessen the financial pain?

Here's a look at the issues:

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Q: What are fund capital gains distributions?

Under federal law, mutual funds are required to pay out any net realized capital gains to their shareholders each year. These gains, which derive from stock trades or other investment income, can be short-term or long-term or a combination of the two.

The type of gain, and therefore its tax treatment for investors receiving it, is based on how long the fund held a particular security--not on how long an investor has owned the fund.

For tax purposes, most funds close their books Oct. 31. Typically, they then tally their capital gains situation in November and pay distributions in December. But payments can be made at any time of the year.

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Q: Should I care about distributions if I own my funds in tax-sheltered accounts?

Probably not. If your funds are in tax-sheltered retirement accounts such an IRA, 401(k) or 403(b) account, any payout you get remains tax sheltered.

Even investors who own funds in taxable accounts may just want to continue gritting their teeth and paying the tax bill if they have been in the fund a long time and plan to continue holding it.

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Q: Who really needs to worry about distributions?

Capital gains payments could be of most concern to investors whose investments are underwater.