How investors can avoid a taxing situation

Of course, the tax tail should not be allowed to wag the investment dog. If you thought the fund was going to soar between now and the record date, you might want to invest now anyway. Most small investors, however, should not engage in this kind of short-term market timing.

If you’ve found an appealing fund that is likely to pay a large distribution, you can also avoid tax by investing through a tax-deferred account such as an IRA or 401(k).

But in your taxable accounts it makes sense to buy funds that aren’t likely to make big distributions this year or in the future. Distributions tend to be biggest in "managed" funds that constantly buy and sell in search of hot stocks. All that selling causes paper gains to be taken, or "realized."

Look for a “turnover” figure, which shows the percentage of the fund’s holdings that change each year. High turnover can mean big distributions. You can find this figure on Morningstar's fund-search Web site.  While there, click the “tax analysis” button. That will show how tax bills produced by distributions have reduced returns in the past.

Index funds, which buy and hold stocks in market indexes such as the Standard & Poor’s 500, tend to have very small distributions — and therefore small annual tax bills. That’s because they rarely sell holdings. Exchange-traded funds, which are index funds that trade like stocks, are also kind to shareholders at tax time.

In addition, there are a number of “tax-managed” funds that use various strategies to minimize taxes. They try to limit turnover and to hold winners long enough to get the lower long-term capital gains tax rate. And they look for opportunities to sell money-losing investments in time to offset gains on winners. You can search for these funds on the Morningstar site.

Finally, stand back and look at the big picture. Do you have investments that can be sold for a loss? When you prepare your tax return, any losses will be subtracted from gains realized through distributions or sales of profit-making investments.

Remember, though, that some funds make big distributions year after year, and you might not have offsetting losses in the future.

So be kind to yourself: Avoid packing your taxable accounts with funds that have a habit of making big year-end distributions.

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