Mutual fund investors: Capital gains can hurt you at tax time

Mutual fund companies are revealing their estimated capital gains payouts for 2010 — and if you're considering buying a fund now, be sure to wait until after it has made its distribution.

This year's distributions aren't as bad as they have been in other years. "A lot of funds still have losses built up from the 2007-2009 bear market that they can use to offset gains," says Dan Culloton, associate director of fund analysis at Morningstar.

But some sectors have done well enough that shareholders will have to give part of their gains to the tax man.

• Gold funds. They have a searing 34% gain this year, and several will make capital gains distributions. Fidelity Select Gold, for example, will pay an estimated $1.71 a share in short-term and $2.25 in long-term gains, about 7% of its current price.

• Energy funds. Vanguard Energy fund's Admiral shares will pay an estimated $3.28 a share in capital gains, about 2.7% of the fund's current share price.

• International and emerging markets funds. BlackRock Pacific will pay $1.10 a share in long- and short-term capital gains. Its total distribution, with dividend income, is 6.9% of its share price.

Some bond funds, too, are doling out capital gains distributions this year, because the bond market has been so hot the past few years. For example, Pimco 7-10 Year U.S. Treasury Index fund will pay $1.05 per share in short-term capital gains this year. That's about 1.3% of the fund's share price.

Funds don't pay capital gains taxes when they sell a stock or bond for a profit. Instead they pass gains on to investors, usually in a year-end distribution. If you're thinking of buying a fund in a taxable account, wait until after the fund has made its distribution. "You don't want to have to pay taxes on gains you didn't receive," Culloton says.

Distributions can be costly. Dividends paid on holdings the fund owned for less than a year are taxed the same as income. Qualified dividends — those on stocks held for more than a year — are taxed at a maximum 15%. Most dividends from real estate investment trusts are taxed as ordinary income. Short-term capital gains, from securities held less than a year, are taxed at your income tax rate. Long-term gains are taxed at a maximum 15%.

When you receive a dividend or capital gains distribution, your fund's share price drops by the amount of the distribution. Most people reinvest the distribution. If you own your shares in a tax-sheltered retirement fund, you don't have to worry about capital gains or dividend distributions.