Why do I have to pay capital-gains taxes even though my fund went down?

QUESTION: I have a mutual fund and I reinvest the dividends. The fund went down this year but I still must pay capital-gains taxes. I don't understand.

— Ida Ethun


ANSWER: Owing capital-gains taxes on a fund that has lost money is the investing equivalent of getting kicked while you're down. And no matter how unfair it feels, it's perfectly legit, and happens with some frequency. Unfortunately, last year it happened even more than usual: In a down year for the markets, mutual funds released an estimated $345 billion in capital gains, up from 1999's $238 billion, according to the Investment Company Institute.

The double-whammy you're experiencing isn't as contradictory as it seems. Imagine that a portfolio manager sells securities the fund purchased years before. True, those stocks took a pounding in 2000 — that's why your fund lost money last year. But they had appreciated for years before that, so the manager sells them at a price higher than their original cost. That's a capital gain. Funds are required to distribute their gains each year. So any investors holding funds in taxable accounts end up responsible for capital-gains taxes. Bear in mind that tax-deferred accounts (such as IRAs and 401(k)s) aren't subject to taxes on these capital-gains distributions.

It doesn't matter whether you reinvest the gains — you'll still owe taxes on them. Nor will taking the distributions out of the fund leave you ahead. When a distribution is made, the fund's net asset value drops by exactly the same amount. So even if you get a check for the distribution, you have no more money — just a tax bill.

Investors who were around to enjoy a fund's earlier run-up may not be too troubled by the looming tax payment. But it's vexing for newcomers who only recently invested in a fund, endured losses, yet find themselves saddled with a tax bill. "In a year like 2000, when most funds lost money, it was sort of rubbing salt in the wound," observes Morningstar analyst Scott Cooley. (See the largest fund families' distributions for 2000.)

If you're looking at a big tax bill now, there's little to do but pay it. But if you've been lax about tax-planning, now's a great time to become more vigilant.

Review your mutual-fund investments and place funds that tend to toss off gains in tax-shielded retirement accounts. As a rule, small-cap, sector and international funds — as well as funds run by an active managers who trade frequently — are likely to distribute more gains than a typical large-cap or index fund, says Michael Chasnoff, a certified financial planner with Cincinnati-based Advanced Capital Strategies.

Become better acquainted with your funds' tax habits. That means keeping an eye on their turnover rates, says planner Scott Kahan of New York-based Financial Asset Management. Beware if a manager consistently has a high — say, 100% — turnover rate. All those transactions can generate a lot of taxable gains.

It's also important to find out when your funds make distributions — periodically throughout the year or in one fell swoop at year end. Read your semiannual reports, which reveal the fund's realized gains for the first part of the year, advises Morningstar's Cooley. And for impending distributions, find out the breakdown between short- and long-term gains — even if you have to call your fund company to learn it.

What's the point? Short-term capital gains will cost you more in taxes. "If it's going to be primarily from short-term capital gains, there's probably very little reason to stay on board," says Chasnoff, who suggests investors seek another portfolio with a similar investment strategy or an exchange-traded fund that's a close match. But that works only if you have held the fund more than 12 months: If you've held it for a shorter time and returns have gone up, you could trigger your own short-term gain by selling, which could be costlier than staying put. (To figure out your cost, read "Calculating Taxes on Fund Sales.") But if you're down in the fund and you know you'll receive a distribution, long-term or short, sell. "You're doing two very good things," says Chasnoff. "You're realizing a loss to go against other income, and you're avoiding the recognition of that other taxable income, which is not really making you any better off."

For more tips on managing your capital-gains burdens, see "Hello, I Must Be Going." The bottom line: It's up to you to track your funds and try to dodge future tax blows — especially if your fund is already down for the count.