It's Time to Look Ahead to the Pitfalls of Capital Gains.

THE road to hell in mutual fund investing sometimes is paved with tax maneuvers.

Remember the old medical joke? "The operation was a success, but the patient died."

You see this, for instance, when a strategy to avoid an income tax bill for capital gains from a fund investment prevents you from making those gains in the first place.

A potential hazard of this sort looms right now as many funds prepare to make year-end capital gains distributions. Between now and the end of the year -- most commonly in December.-- these funds will pass through to shareholders the net profits they have realized on whatever holdings the manager sold during the year.

Nine out of 10 investors have those distributions automatically reinvested in new shares. Unless they hold their funds in tax-deferred retirement accounts, though, they still have to report the distributions as capital gains on their income tax returns for the year.

Knowing this, many investors try to bob and weave. Though it's hard to avoid distributions on shares they already own, they may put off buying any additional shares until after the distribution is made.

"Vanguard Issues Cautions About Year-End Capital Gains Distributions," reads the headline of a press release from the nation's second-largest fund firm, the $575 billion Vanguard Group in Valley Forge, Pa. "The tax-conscious investor may want to delay a considerable share purchase."

If you read the headlines, but not the details, of such warnings, it's easy to get the impression that it's always wise to defer fund investments in the last few months of the year.

Not so. In its report, Vanguard says, "one exception to this rule is for the investor making modest share purchases on a regular basis" For this worthy individual "the tax liability is likely to be minor relative to the overall size of their investment."

I'd take that much' further. For every investor, postponing a planned investment of any size is a gamble.

The risk is that when you buy a few weeks or months from now, the price will be higher -- so much higher that the gain you forgo comes out much larger, after taxes, than whatever you saved on taxes.

For a real-life illustration of this, look no further than the stock market a year ago. The Nasdaq Composite Index jumped 48 percent in the fourth quarter of 1999, supercharged by computer and telecommunications stocks.

Over the same stretch the Standard & Poor's 500 Index rose "only" 15 percent. Even that was a lot to miss, though, for the sake of saving a few bucks on taxes.

Follow me through some simple arithmetic. Let's say you invested $10,000 in a stock fund on Sept. 30, 1999, just before the fund rose 15 percent in the fourth quarter. Your wise-guy brother held back until year-end, though, correctly anticipating that the fund would make a 15 percent gains distribution on Dec. 31.

How do each of you come out? Your money grows to $11,500, minus federal capital gains taxes of $345 (20 percent of a $1,725 capital gains distribution). That nets out to $11,155.

Your brother kept his $10,000 in a tax-free money market fund through the fourth quarter, earning $100 in dividends. So when he buys into the stock fund at year-end, his position is worth $10,100. You're $1,055 ahead of him.

Also, don't forget that you never have to pay gains taxes on the same money twice. After the $1,725 distribution is reinvested, your tax basis -- the cost used in computing any gain when you eventually sell your fund shares -- increases by that amount, to$11,725.

OK, you may say, put your calculator away. We're never going to see another fourth quarter like last year's Heck, the market could drop between now and the end of 2000, hitting investors who buy today with a double whammy.

True enough. Nobody knows what this year's fourth quarter, or next year's, or any other future period will bring. But if you keep back an investment over any of those periods, you give up a possible gain of unknown size. Numerous studies in recent years have shown that most stock market gains occur in a few short periods, which often come when least expected.

We can all agree, I think, that gains taxes on annual fund distributions are a pain in the wallet. But if your reaction to them sidetracks your investment plan, that only compounds the problem.

Chet Currier is a columnist for Bloomberg News.