Don't buy a tax liability

This time of year can be a danger-ous one for mutual fund inves­tors.

It’s distribution time – when mutual funds pay out some of their lar­gest taxable distributions of income and capital gains during the year.

If you’re buying mutual funds in a taxable account, these distributions are taxable to you, whether you rein­vest  them  in  new shares or let them go to cash. Investing a large a­mount (say $1,000 or more) in a mutual fund just before a big dis­tribution is a bad move. You pay tax on the distribution but get no real benefit from it.

Before investing toward the end of the year, smart investors check with the fund company to deter­mine whether they’re buying a tax liability. If the distribution will be more than 5%, it’s pro­bably better to wait until on or after the fund’s “ex-date” to buy your shares.

This year is expected to be worse in this respect than the past few years. After the dot-com bubble burst in 2000-2001 many funds had years worth of capital losses to carry forward, which reduced or eliminated the capital gains distributions that they were forced to pass on to investors. Now, many funds have used up their losses and can no longer offset their gains.

Some of the most tax-efficient funds are ETFs and index mutual funds, since, due to their nature, their port­folios have less turnover. However, even some actively managed mutual funds are efficient, because they strive always to offset gains with losses.

If you are considering buying a mu­tual fund in a taxable account, it’s a good idea first to check the fund’s tax efficiency.