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First, the good news: Thanks to a robust market, mutual funds are expected to make an estimated $200 billion in capital-gains distributions by yearend. The bad news: That means investors could get a $20 billion 2006 tax bill.
If you intend to purchase or sell a mutual fund before Dec. 31, find out if it plans to make payouts and if so, when. Don't buy until after a distribution, "otherwise you'll be paying for the gains you weren't there to enjoy," says Morningstar analyst Christopher Davis. If you're thinking of selling a fund in which you have long-term gains, you might want to get out before payday if the fund is going to be making short-term capital gains, which are taxed at rates as high as 35%. Long-term gains, whether triggered by your sale or by the fund's payout, are taxed at a 15% maximum.
Funds that are likely to post the biggest distributions are typically the best performers. At the top of the list are small-company value funds, which enjoyed gains even during much of the bear market of 2000 to 2002. In addition, natural-resource funds are expected to make big payouts--about one-quarter of the distributions are expected to be for short-term gains. (Most large-company funds, meanwhile, still carry losses.)
How do you know if a taxable event is heading your way? Most funds put distribution information on their Web sites. Or call the fund company's toll-free number. By Lauren Young