I want to begin investing in mutual funds, but I'm worried about the tax consequences of capital-gains distributions. Should I invest now -- or wait?

QUESTION: I want to begin investing in mutual funds, but I'm worried that I'm too close to the December tax-distribution season. Is it better to wait until after December -- or should I purchase shares now? If I were to invest before the distribution date in December, would I avoid taxes, since most funds have had a loss throughout the year?

-- John Dacles
ANSWER:

What you're worried about is the mistake known as "buying the distribution." By purchasing mutual-fund shares shortly before a distribution, you end up saddled with the tax burden without having been around to enjoy the gain. Of course, none of this is a concern if you hold funds in tax-deferred accounts such as IRAs or 401(k)s, which aren't subject to taxes on capital-gains distributions.

And don't assume that the losses incurred by most funds this year mean they won't have taxable gains. True, equity mutual funds are down an average of 20.17% year-to-date, according to Lipper, a mutual-fund-research firm. But many funds may nevertheless have booked gains on some trades over the course of the year. For example, the Morgan Stanley Institutional Technology fund (MSITX) is down approximately 60% for the year, but still issued a capital-gains distribution in July. "The taxable gains that funds pay out are not 100% correlated with investment returns on the funds," says Stephen Barnes, a certified financial planner in Phoenix.

So if the fund you're investing in is expecting a big capital-gains distribution, you might want to wait. Most major fund families post the date and expected size of distributions on their Web sites, though these typically don't start appearing until November or December. In the meantime, you might call each mutual fund you're interested in and ask what it expects to pay in distributions, Barnes says.

But before you decide to sit it out until after distribution season, take a look at your overall tax liability as well as your investment goals. "You can't micromanage your portfolio by one fund choice or that fund's distribution scheduling," says David Feldman, a CFP at Wechter Financial Services in Parsippany, N.J. If you've booked some capital losses this year (which may very well be the case), these can be used to offset taxable gains.

And how will these funds fit into your overall financial plan? The funds you choose should fit in with your investment objectives, suit your risk level and have good track records, says Feldman. Over the long term, the benefits could outweigh the pain of the initial tax bite. And remember, we're still two months or so away from the height of distribution season. That's two months during which this beaten-down market could -- could -- stage something of a recovery. If that happens, being tax-phobic now means it'll just cost you more later to buy the funds you want.

If you really want to minimize your potential tax liability, you could invest in some tax-managed funds. These are run with an eye for tax efficiency. Other funds are tax efficient without necessarily being labeled as such, including indexed funds or other funds with low portfolio turnover. And again, an easy way avoid the tax trap altogether is to invest in mutual funds in a tax-deferred account.