We tend to treat mutual fund distributions like a trip to the dentist. As painful as they seem, we forget that there generally is a good reason for both.

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Here's part of the problem: Over the first eight months of the year, the average capital gains distribution -- the taxable profits generated by portfolio changes that get passed along to fund shareholders -- was about 75% higher than it was over the same period last year, according to

Morningstar

. Not to mention that the number of funds making distributions has rocketed. So it's no wonder that these distributions are easily equated with root canals.

But there's a silver lining to these distributions. Capital gains distributions and reinvested dividends are added back to your cost basis, i.e. your original cost, in the fund. So while you do have to pay Uncle Sam in the year of the distribution, you will owe less tax when you decide to sell your shares in the fund.

But many mutual fund shareholders don't keep track of their basis, says Paula Kennedy, a senior manager in the in private client advisers group at

Deloitte & Touche

. "So they have no idea how these distributions affect them." They just see a big tax bill. But adjusting your basis for these distributions can be help ease the pain.

Of course, if you recently purchased shares of a mutual fund only to find out that a month later it is going to make a big capital gains distribution, you have a right to be perturbed. "From now to end of December, be careful which funds you buy because you could be susceptible to distributions on gains you did not participate in," warns Ben Tobias of

Tobias Financial Advisors

in Plantation, Fla. But if you've researched the fund and decided to dive in for the long haul, don't let this little blip make you too crazy.

Understanding how these distributions affect your cost basis in the fund can help control the hysteria.

Basis Basics

Your mutual fund can make two types of distributions. An income distribution is what's left from all interest and dividend income earned by the securities in the fund after the fund's operating expenses are subtracted.

A capital gains distribution is the profit a fund makes when it sells securities. So if your fund bought

Dell

(DELL) - Get Report

at $33 in early June 1999 and sold it at the end of March 2000 for $52, a $19 capital gain is realized. Those realized gains must be distributed to fund shareholders. So in a way, capital gains distributions are a good thing. They mean your fund made money. And, therefore, as a shareholder, so did you.

If you hopped in the fund in October, you may be getting a piece of that distribution, even though you were not around for the 10 months that the fund benefited from holding Dell.

Any capital gains distributions and reinvested interest income, like your dividend distributions, should be added back to your cost basis in the fund. In addition, if you paid sales charges or transaction fees when you bought the shares, don't forget to add those charges to your cost basis. On the flip side, any fees or charges you pay when you sell shares should be subtracted from your sale proceeds.

Adding distributions to your basis can minimize the tax pain when you sell because the size of the taxable gain will be smaller. That means you owe less tax.

In simplest terms, let's say you bought a fund for $1. A year later, you received a $4 short-term capital gains distribution. You will owe tax on that $4 at your regular ordinary income tax rate.

Now you're upset. But remember, you must add that distribution to your basis in the fund, so your basis hops to $5. A few months later, you decide to sell the fund. Let's assume the fund is trading at $8 a share and you'll owe a 50 cents-a-share transaction fee on the sale. You'll pay tax on only $2.50 ($7.50 - $5) -- not $7 ($8 - $1) as some fund shareholders incorrectly believe.

Granted, it's a small consolation when you get hit with an unexpected tax bill in the year of a distribution, but at least it's not for naught. "It's generally a relief for people when they realize that their basis has increased over time," says Kennedy.

And if you own actively traded funds, get used to this. The active fund manager most likely makes a lot of trades, so expect lots of distributions. In an active fund, you essentially pay tax as you go.

This is very different from an inactive fund that makes few or no distributions. "It just like holding a share of stock," Kennedy says. "It's more than likely that you'll owe more in tax on the index fund

at the time of sale." Of course, deferring tax is better because then you have more money to grow over the years.

Tracking the Tedium

So how do you keep track of the cost basis in your favorite fund? I'm not going to lie to you: It's an exceptionally tedious task.

You could create an Excel spreadsheet, or use Quicken or another personal-finance software. Then be diligent about entering every distribution or fund share purchase so that your basis is automatically and continually updated. You also could turn over the job to an accountant and let him deal with the monotony.

At the very minimum, keep the statements from your mutual fund company. Since most fund companies keep track of your basis for you, your statements will give you a feel for where you stand at the end of each quarter. If you haven't been saving them, call your fund company and ask for help.

If you start keeping track of your fund shares' cost basis, you're not as likely to break out in hives every time your fund makes a distribution. And, while you're at it, why not start flossing, too?

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