Mutually Surprising Tax Hits

It's capital gains season again for those of you who hold -- or are planning to buy -- mutual funds in taxable accounts.

And depending on what fund you're talking about, this year may hold more tax surprises than most recent years. Why? I'll get to that in a minute.

First, let me refresh you on how capital gains distributions work. Most funds, especially the actively managed variety, buy and sell stock and other securities throughout the year. As the security portfolio gains value through the year, so does the so-called "Net Asset Value," or NAV, of the fund. So your shares increase in value through the year.

As required by investment company law, funds must distribute capital gains exceeding recognized capital losses each year.

So sometime during the fourth quarter, the fund manager tallies gains in excess of recognized losses for the year and declares a capital gain and distribution date. Most of these distributions occur in December.

There's nothing new about this procedure. But what is new: For the first time in several years, many funds have sizeable gains to distribute.

Why? One simple answer: strong markets. But more than that, mutual funds are allowed to carry forward net capital losses to offset gains for eight years. Many funds incurred losses as the bull market unwound in 2000 through 2002. But now those losses have been exhausted, bringing better gains than ever at least for some funds.