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If You Can Navigate the Cap-Gains Minefield, Year-End Treasures Await

Buying funds is tricky now; here's a map for avoiding some bombs.

Thanks to giant, impending capital-gains distributions, buying shares of a big-cap growth fund these days has a very Russian roulette feel. Yet, there are reasons to take the risk and a few ways to minimize it.

First, let's review this year's cap-gains nightmare, which we've all been

talking about.

Last year, more than 150 funds posted

returns over 100%; this year, managers are selling some of their sagging winners and realizing big capital gains in the process. And when those gains outweigh a fund's accumulated losses, funds have to pay them out to shareholders like you. Most investors reinvest these gains in additional fund shares, but if you don't own the fund in a tax-deferred account, you have to pay taxes on the gains.

And these taxes aren't anything to sneeze at, with average investors paying a 20% tax rate on their capital gains. For instance, if you owned 1,000 shares of a fund selling at $10 -- a $10,000 investment -- and the fund paid a $1 per-share capital gains distribution, you'd owe Uncle Sam $200 in April. Of course, you can book losses to offset these gains, but if you own several growth funds these gains can add up in a hurry.

If you've held your fund shares for at least the past year or two, you don't have much to complain about since you were along for the profitable ride. But if you buy a growth fund now, just prior to its year-end distribution, you'll essentially pay taxes on others' gains -- and no one should be that nice.

This year, the odds of that happening are higher than usual. In the first eight months of last year, some 420 stock funds paid out capital gains distributions; in the first eight months of this year, that number rose by about 100 funds.

More important, this year's cap-gains distributions are not just more plentiful, they're also more painful. These payouts are considered outsized when they're more than 10% of a fund's

net asset value (NAV) or share price. In the first eight months of last year, 16 funds topped this high-water mark. Through the end of August more than 50 earned the unenviable honor this year.

Amid the wreckage are some fairly daunting examples, like the

(WPJPX)

Warburg Pincus Japan Small Company fund, up over 250% last year and down more than 50% this year, which paid out a cap-gains distribution

equal to 55% of its NAV back in August. Just before that, the

(SDCEX)

Standish Small Capitalization Tax-Sensitive Equity fund -- which is suppose to minimize taxable distributions -- saddled its shareholders with a gain that topped 14% of its NAV.

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With most stock funds closing their books between now and the end of the year, you might be tempted to just keep your money parked in that cozy money market fund and hold off buying a fund until next year. But judging from reader emails, many investors want in now.

And there's actually a good reason why.

At least some of this year's selling has been overblown, due to fund managers'

tax-loss selling -- dumping losing positions simply to reduce a fund's capital gains. A fund manager's worst fear is paying a fat cap-gain distribution at the end of a losing year becuase that's the textbook double whammy that often sends shareholders packing. So, with most

tech/telecom-heavy growth funds underwater this year, many growth fund managers dumped sagging positions en masse. Selling for tax reasons -- rather than investment reasons -- often creates intriguing opportunities.

At the same time, managers have let a fairly stunning amount of

cash build up in their funds, often an indictor of brighter days ahead on Wall Street. Once funds' tax selling ends, this gush of cash could boost stocks in a hurry.

If you're one of those folks licking your chops on the sidelines with a bonus or some other pool of cash you've earmarked for a growth fund, you can avoid a tax headache by simply buying funds in tax-deferred retirement accounts like your 401(k) or individual retirement account (IRA).

You might start with our most recent screens of the

large-cap growth,

mid-cap growth,

small-cap growth,

tech- or

telecom-fund categories.

If you're looking to buy funds in a taxable account, you don't have to wait until the end of the year, either. No matter which fund you choose between now and the end of the year, make sure you call the fund company before you pull the trigger. Ask them if the fund is going to pay a distribution this year, and, if so, when you can buy shares without setting yourself up for a tax hit -- usually the day following the "record date." Many fund shops have posted distribution estimates and record dates on their Web sites.

The Damage
Some fund shops have posted their cap-gains estimates on their Web sites

Fidelity

Vanguard

American Funds

Franklin-Templeton

T. Rowe Price

American Century

OppenheimerFunds

Oak Associates

Invesco

Legg Mason Funds

Dresdner RCM Funds

Source: The mighty Internet.

In looking for funds, you might check out one that a favorite manager just started or took over. The idea here is that the fund where the manager made his name might have high-embedded cap gains, but the new fund or new charge will give you the same management without the tax hangover.

Bill Miller, who has compiled a legendary record running

(LMVTX) - Get ClearBridge Value C Report

Legg Mason Value Trust, started the more concentrated

(LMOPX) - Get Miller Opportunity C Report

Legg Mason Opportunity fund at the start of this year. And Bill Nygren, who has long wowed investors running

(OAKLX) - Get Oakmark Select Investor Report

Oakmark Select, shouldn't have any tax issues with the loss-laden

(OAKMX) - Get Oakmark Investor Report

Oakmark fund he took over in March.

If you're thinking

Janus'

high-octane growth style is due for a rebound but don't like the Janus funds that are open and probably stuffed with unrealized cap gains, think about the

Janus 2

fund, due to launch at year-end. The fund looks to be run in the same style as the firm's flagship

(JANSX)

Janus fund, but it's starting with a clean slate taxwise.

If you're shopping for a tech fund, the managers of the biggest (

(PRSCX) - Get T. Rowe Price Science & Tech Fd Report

T. Rowe Price Science & Technology) and arguably the best (

(TVFQX)

Firsthand Technology Value) tech funds just rolled out new global tech funds at the end of September. T. Rowe's Chip Morris just launched the

T. Rowe Price Global Technology

fund. And not to be outdone, Firsthand's Kevin Landis, whose Technology Value fund tops all funds over the past five years, launched the

Firsthand Global Technology

fund.

Finally, and predictably, you might look at an index fund. Yes, several

Vanguard

funds are paying out

significant gains this year, but notably absent from that list is the nation's largest mutual fund, the

no-load and ultra cheap

(VFINX) - Get Vanguard 500 Index Inv Report

Vanguard 500 Index fund.

If I'd told you last year that tobacco titan

Philip Morris

(MO) - Get Altria Group Inc Report

, up 61.7% since Jan. 1, would be up more than

Microsoft

(MSFT) - Get Microsoft Corporation Report

(minus 41.5%),

Cisco

(CSCO) - Get Cisco Systems, Inc. Report

(up 6%),

Intel

(INTC) - Get Intel Corporation Report

(up 11.8%) and

Dell

(DELL) - Get Dell Technologies Inc Class C Report

(minus 36.2%), you probably would've wondered what I was smoking, but I guess that's the kind of year it's been.

Ian McDonald's Fund Junkie column runs every Monday and Wednesday, as well as occasional dispatches. Also, check out the weekly 10 Questions, which runs under the Fund Junkie banner on Monday mornings. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.