How much tax should you pay on reinvested capital gains distributions from your mutual funds?

Nothing. At least that’s the idea behind a bill introduced in July to the U.S. House. Investors would not be taxed until they sold the fund shares bought with the distributions.

But just in case the bill doesn’t pass – similar ones have stalled in committee in recent years – you can take some steps to minimize this tax on your own.

For investors with taxable accounts, the House proposal, and a companion introduced in the Senate in May, would be a valuable change. Currently, distributions from mutual funds are taxed in the year received, even if they are automatically reinvested in the fund. This can create huge headaches at tax time.

When a fund manager sells a holding, such as a stock or bond, the original purchase price is subtracted from the sale price to produce a capital gain or loss. Late in the year, all the sales are tallied, and if there is a net gain, it is paid to fund investors, usually in November or December.

Rather than pocket the payment, most shareholders have the distributions reinvested. But they have to pay tax on the distribution unless the fund is held in a tax-deferred account like a 401(k) or IRA. The taxable amount is reported in the 1099 form that comes from the fund company in January.

In some years, this involves a lot of money. The biggest distributions ever came in 2007, when ordinary investors with taxable accounts received $147 billion, according to the Investment Company Institute, the fund industry’s trade group. That was caused by the big stock market gains of the previous two years. Last year the comparable figure was just $35 billion, reflecting the much weaker market.

In some cases the distributions are whoppers. In 2007, for example, the American Century Ultra Fund (Stock Quote: TWCUX) made capital gains distributions equal to about one-third of the share price.

Under the bipartisan bill introduced in the House, the Generating Retirement Ownership Through Long-Term Holding Act, or GROWTH Act, the tax would be postponed until the fund shares were sold. Since that could be many years later, money that would otherwise be used to pay taxes could be invested and enjoy many years of compounding. The bill is sponsored by Representatives Paul Ryan (R-WI), Artur Davis (D-AL) and Joe Crowley (D-NY).

Since there’s no assurance this tax-cut will be approved in a year when money is tight, investors can take steps to minimize the tax bite on their own.

The first is to avoid using taxable accounts for funds that tend to have large distributions. Use IRAs, 401(k)s or similar tax-deferred accounts for those funds. Actively managed funds with lots of turnover, or changes in holdings, tend to have bigger distributions than passively managed index funds.

Morningstar Inc., (Stock Quote: MORN) has distribution information on its Web site. In looking at a fund, click the “Tax” tab. Also scan down for a distribution history near the bottom of the “Quote” page.

The second strategy is to avoid investing in funds just before they make their year-end distributions. When the distribution is paid, the fund’s share price drops to reflect the fact that assets have been removed. So the investor is no richer the day after the distribution than the day before.

By postponing a purchase until after the distribution, your money will buy more shares at a lower price, and you won’t be hit with a tax on the distribution. Not that year, anyway.

Use the Savings, Taxes and Inflation calculator for a sense of how taxes can stunt your investment results.

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