THE GOOD THING about equity mutual funds is that they're managed by professionals. The bad thing (besides the fees) is that you have virtually no control over taxes.
Now, you're probably saying you never have any control over taxes -- and in the existential sense, you're probably right. But when you own stocks individually, you decide when to sell them and whether to take a hit from capital gains. If you own a fund, the manager makes those decisions and you get stuck with the consequences -- like them or not.
It works this way: If the sum of a mutual fund's transactions during the year adds up to an overall gain, you'll receive a taxable distribution. That's because funds are required to either pass out all of their gains each year or pay corporate income tax on them. When you get a distribution -- even if you have it reinvested -- the tax bill becomes yours. And depending on whether the gains were short or long term, you'll be paying either your regular tax rate or the capital-gains rate. (You'll receive a Form 1099-DIV from your fund that lays out exactly how much of each kind of income you've received.)
If your fund's returns are exceptional, a taxable distribution might not be such a big deal. But if they are merely average, the tax bite can hurt. The worst-case scenario is when you buy a fund close to its distribution date (usually at the end of the year) and get stuck owing taxes on transactions that occurred before you owned the fund. This miserable phenomenon is known as "buying the distribution."
This problem doesn't apply, of course, if you hold the fund in a tax-deferred retirement account. In that case, your distributions are reinvested and you pay no taxes. But even in a taxable account, there are things you can do to minimize the damage.
Check the Distribution Date
It's always dangerous to buy mutual funds at the end of the year, since you may be buying right into a big taxable dividend. If you are purchasing shares of a fund in the fall, check the distribution date and wait until it passes before writing your check.
Stick With Index Funds
A fund that simply mimics a stock index like the S&P 500 follows the ultimate buy-and-hold strategy. It buys those 500 stocks and hangs onto them for better or worse. That minimizes taxable distributions.
Buy a 'Tax-Managed' Fund
These guys also lean toward buy-and-hold, which keeps turnover to a minimum -- anything less than 20% would be low. When they do sell a security for a gain, they will attempt to offset it by selling some losers in the same year.
Avoid the Churn
Funds that actively "churn" their stock portfolios in an attempt (sometimes futile) to maximize returns will usually generate hefty annual distributions in a rising market. The size of these payouts can be annoying enough, but it's even worse when a large percentage comes from short-term gains. If you spot a fund you like, check out its turnover rate. If it's higher than 100%, beware the tax bill.
The bottom line: If you'll be investing via taxable accounts, look at what kind of after-tax returns various funds have been earning. Funds are required to display this information in their prospectuses, so with minimal research you see how much investors actually got to take home after the IRS took its share. After-tax returns are presented alongside pretax returns for the one-, three- and five-year periods. Keep in mind, however, the figures are calculated for folks in the highest tax bracket.