IN FUNDS, GOOD YEAR OFTEN TAXING.

Byline: Chet Currier Associated Press 

The season of the year is approaching when many otherwise happy mutual fund investors must deal with one of the troublesome quirks of the funds. You might call it the Capital Gains Complication.

The problem arises from the rules that require funds to pass through to their shareholders each year substantially all the capital gains they have realized since Jan. 1.

Some fund investors take this distribution in the form of a check. Many more have it automatically reinvested in additional fund shares.

But regardless of which way you handle it, the capital gains distribution is what accountants call a taxable event. Whether you are investing for some immediate purpose, or some goal many years in the future, you must face a reckoning with Uncle Sam each year on a substantial amount of the progress you achieve.

The bullet can be dodged if you are operating within an individual retirement account, Keogh plan, employer-sponsored 401(k) account or some other tax-deferred retirement savings program. In these vehicles, no taxes are due until you withdraw money.

But that won't help you with savings that you invest beyond the annual IRA, Keogh and 401(k) limits, or for purposes like children's education that a retirement plan isn't set up to accommodate.

If you invest directly in individual stocks, you usually can choose when to realize any capital gains.

You have the same option with fund shares, to the extent that their net asset value increases reflecting unrealized gains on stocks held in a fund's portfolio.

But you don't have any say over the gains a fund manager chooses to nail down by selling appreciated securities. That amount can vary greatly from one fund to another, depending on the manager's style.

It may be a very small percentage of the total, for instance, in a stock index fund or other fund that makes relatively few changes in its holdings. It may be a big chunk, by contrast, in a fund with high portfolio turnover.

Capital gains distributions may occur in any type of long-term fund that might realize a profit on a security sale - even a so-called tax free municipal bond fund.

Gains are likely to be especially plentiful at a time like now, when stock funds have been riding the crest of a bull market.

By way of illustration, suppose you own 1,000 shares at $10 a share when the fund makes a year-end capital gains distribution of $3 a share. Presto - $3,000 in taxable income goes into your accounts, from an investment worth just $10,000.

If you reinvest the $3,000, it goes to increase the ``cost basis'' of your holdings, reducing the taxable gain you will realize when you eventually sell your fund shares. But in the meantime, you still have to come up with the money to meet the current tax obligation.

How to avoid, or at least minimize, this hassle? First of all, you can invest as much as possible through tax-deferred plans such as IRAs.

Also, you can seek out funds for your taxable accounts that customarily realize few gains each year, such as the aforementioned index funds.

Lastly, you can soften the blow by holding off on new purchases of fund shares late in the year, just before distributions are made, and waiting to buy until after the distribution date.

Many funds stand ready at this time of year to advise you of the prospective size and timing of distributions they expect to make.

But if you give this tax angle too much emphasis in your planning, it might scare you away from the funds that can do the best job of helping you reach your investing goals.

After all, there's a limit to how much you can accomplish. In growth investing set your mind on avoiding capital gains.

So you may decide you don't have much choice but to accept some annual taxes on capital gains distributions as a necessary cost of doing business in the world of mutual funds.