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Brace for Big Capital Gains

Many funds will be unloading big gains on investors.

If you own a stock fund, chances are your tax bill will be bigger this year.

Mutual funds must pay out virtually all of the capital gains they realize for the 12 months ended Oct. 31 to avoid paying excise penalty taxes at the fund level. Most declare dividend and capital gains distributions in December of each year. The payments don't change the value of your funds, but you owe income taxes on the amount disbursed.

The average U.S. stock fund returned 15.76% for the 12 months ended Oct. 31, according to Ratings. By comparison, the total return for the S&P 500 over the same period was 16.33%, assuming reinvestment of dividends.

Market performance isn't the only determinant of the size of your tax bill, however. Funds don't incur capital gains until they actually sell a stock. So in some cases, investors will be taxed on the amount a stock in the portfolio has appreciated over the past years.

Additionally, some funds have used up a tax benefit that lowered reported gains. In recent years, a number of funds have been able to carry forward tax losses incurred at the beginning of the decade when the tech bubble burst, offsetting capital gains.

Sam Beardsley, director of investment tax at T.Rowe Price, says the effect of tax loss carry forwards has disappeared for most funds this year, with the exception of those that specialize in tech stocks.

Because funds can carry tax losses forward for up to eight years, tech funds that got hit hard in 2000 may continue to offset gains for a couple more years.

The Baltimore money manager expects to make capital gains distributions on 44 of its 56 retail equity funds this year, up from 41 in 2005. These 44 funds will be paying out about 3.96% of their net asset value, on average, up about 30% from an average of 3.05% of NAV last year.

Not surprisingly, the outliers -- those paying out more than 10% of net asset value -- are invested in some of the stock market's hottest sectors, such as the

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New Asia fund and the

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European Stock fund.

The story is similar at other fund firms. Federated Investors expects to make capital distributions on 16 stock funds, compared with 12 in 2005, according to information posted on the company's website. (This year's count excludes four MDT Adviser funds that Federated acquired in July, all of which are making capital gains distributions.)

One of the funds that didn't make distributions last year, the

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Balanced Allocation fund, is paying out 86 cents a share, or 8.16% of NAV.

At Oppenheimer, 29 funds are planning year-end capital gains distributions, compared with 28 in 2005, according to a spokeswoman.

At Vanguard, 29 stock funds are planning year-end capital gains distributions this year, up from 25 in 2005, according to the company's website. Among the additions are

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International Explorer, which expects to pay out 8.37% of NAV,

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International Growth, which is paying out 8.27%,

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International Value, which is paying out 8.18%, and

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Mid-Cap Growth, which is paying out 16.11%.

While many money managers advise against purchasing funds just before they make payouts, Beardsley says that the money you pay in taxes isn't lost forever; it just means you'll owe Uncle Sam less when you eventually sell your shares in the fund. (When you sell your fund shares, you incur a loss or gain on those securities but deduct the capital gains tax and/or dividend tax you have paid on distributions each year. In essence it is a wash. The real issue for investors is mainly cash flow.)

In most cases, he says, you're better off worrying about movements in the market than the timing of your tax bill. "If you like a stock fund and you think it may do well in the month of December, you might want to buy it anyway," he says. "Certainly I wouldn't worry if

the payout was less than 10% of NAV."

Of course, if you invest through a tax-sheltered account, such as an IRA or a 401(k) plan, there's nothing to worry about.

Allison Bisbey Colter joined in 2006 from the New York office of Dow Jones Newswires, where she spent the previous seven years covering consumer finance, mutual funds and hedge funds. Prior to that, she worked in Europe for Dow Jones covering transportation from London and Italian capital markets from Milan. She is a graduate of Wesleyan University, where she received a BA in government.