Mutual Fund Investors: Beware of Undeserved Year-End Tax Bills

NEW YORK ( MainStreet) -- All in all, 2014 has been a decent year for stocks and stock funds. Not as great as 2013, but good. Now for the downside: Mutual fund investors need to watch out for an unexpected, and in some respects undeserved, tax bill - a matter to consider in any investments made between now and the end of the year.

The issue involves tax on year-end capital gains distributions. This can hit any fund investor, but it's especially nasty for those who invest late in the year. They can end up owing tax on gains they didn't actually enjoy, and the risk is especially high after the stock market has done well. That's the case now, with the S&P 500 gaining nearly 10% this year on top of 32% in 2013.

Capital gains tax applies to an asset that is sold for more than was paid. If you bought a stock a few years ago for $100 a share and sold it this year for $150, you'd be taxed on the $50 gain. That would cost $12.50 if you were in the 25% tax bracket. (This applies to ordinary taxable accounts, not tax-deferred accounts such as IRAs and 401(k)s.)

It works the same way for a mutual fund. Near the end of the year, the fund tallies the gains and losses on stocks or other holdings sold during the year, and any net gains are paid out to the fund's investors. These payments are easy to overlook because many people have them automatically reinvested in more fund shares, but they are taxable nonetheless.

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