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If you’re one of the millions of Americans who invest in mutual funds, get ready for a tax shock. The 1099 tax form you’re getting soon is likely to mean a much bigger tax hit than ever incurred before.

A confluence of events has forced many funds to pay out unusually large capital gains distributions. That may sound like a good thing, but if your money is invested in a taxable account, you could be socked with a big tax bill from Uncle Sam, even if you never sold a share of your mutual fund investment. However, if all of your mutual funds are stashed in tax-free or tax-deferred accounts — such as 401(k)s and Roth IRAs — you don’t have anything to worry about, and can stop reading right here. Well, I take that back. There’s some really good stuff that you’ll need to know to avoid making investment mistakes that could lead a tax hit next year or in years to come.

Overall, the stock and bond markets performed pretty well last year. The S&P 500 (^GPSC) was up more than 11 percent. More importantly, the bull market is now in its sixth year, and many stocks have doubled in value since bottoming out after the financial crisis. In recent years, mutual funds (and individual investors) were able to use losses incurred during the recession to offset some or all of the gains that came later, but those losses are all used up by now.

Understanding the Capital Gains Tax

Here’s how the tax law works. If you own an individual stock, you are required to pay a capital gains tax when you sell it, if you made a profit. For most people, that’s 15 percent of the profit. But if you own a mutual fund, you pay as you go, even for long-term buy-and-hold investors. If the fund sells stocks that have appreciated, it is required to distribute those gains to shareholders each year. And if you own that fund in a taxable account, you will have to pay the capital gains tax.

“The way mutual funds work, investors are hit with a tax bill whether they sold or not,” according to David Santschi, chief executive of TrimTabs Investment Research. He notes that many actively managed funds were indeed very active. “It surprises me how actively some of these funds trade,” he said, noting that some have a turnover rate of 150 percent or more, meaning that they have in essence bought and sold everything in their portfolio more than once during the calendar year, and that can trigger a big tax bill for investors.

“After the long rally, many funds are selling some of their highly appreciated winners,” says Christine Benz, director of personal finance at Morningstar (MORN). “This phenomenon comes in waves, along with a sustained bull market.” By some estimates, 2014 will go down as one of the worst years ever for fund distributions.

A Lot of Distributions

Mark Wilson, chief investment officer at Tarbox Group, says he has found more than 500 funds that distributed more than 10 percent of the net asset value last year, which he says is a record for the industry. Some examples from popular funds: the Vanguard Explorer Fund (VEXPX) paid out more than 13 percent of its net asset value; Fidelity’s International Small Cap Fund (FISMX) paid out nearly 16 percent; and American Funds’ Growth Fund of America (AGTHX) paid out nearly 10 percent.

How much will you owe in taxes on those big distributions? If you’re in the 25 percent income tax bracket and you own $10,000 worth a fund that pays out 12 percent of its net asset value, you will owe $180 in taxes. ($10,000 times the 12 percent distribution equals $1,200. Multiply that times the 15 percent cap gains rate equals $180.)

It’s too late to do anything to change what happened last year, but the experts say understanding the rules can help you avoid some the tax pain going forward. Some investment managers might argue that the tax you owe probably means you made a profit and that you shouldn’t complain. Not so, says Benz. She says taxes are not a natural outgrowth of making money. “This wave of cap gains distributions makes me think that I would be hard-pressed to say individuals should hold actively managed funds in their taxable account.” She and others suggest that investors hold those funds in tax-deferred accounts instead, and use index funds and exchange-traded funds for your taxable accounts. That way, you have much greater control over when to incur the tax. It’s also worth noting that about 80 percent of the thousands of actively managed mutual funds on the market failed to outperform their index target.

Investors worried about big distributions in 2015 and beyond might be tempted to sell some of the tax-inefficient funds they hold, but that presents a Catch-22 situation. Such preemptive selling could trigger a cap gains bill on the sale of those shares that could be larger than anything you get hit with through the annual distributions. The bottom line is investors need to be aware of the tax obligations you might incur before making any future investments in taxable accounts.

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