These days, investors may well find that their list of worries is long and growing: Slow global growth, a slumping stock market, meager bond yields, and eventual interest-rate hikes all loom large.

But there is another risk that investors should have on their radars: the risk of a big taxable distribution from one of their mutual funds. Even though stock performance has been weak in the past three months, many mutual funds still have highly appreciated securities in their portfolios in the wake of stocks’ six-plus-year rally; those gains have not been taxed yet. But if they confront some triggering event—such as sizable asset outflows or a manager change that prompts the sale of those highly appreciated securities—those gains can go from unrealized to realized in a hurry. Those gains must then be distributed to shareholders and are taxable, assuming the investor holds the fund in a taxable account.

Some investors might count mutual fund capital gains distributions as a necessary evil, just part of the cost of making money. But that is only partly true. Tax-savvy investors might also rightly point out that reinvested capital gains distributions boost cost basis, so they are not as costly as they might first appear. However, it is usually a good idea to avoid paying taxes for as long as you can rather than owing them on a year-to-year basis, as is the case with mutual fund capital gains distributions.

As mutual fund capital gains distribution season is about to kick off in the fourth quarter, here are some key dos and don’ts to bear in mind.

Do: Be on high alert if you hold mutual funds in your taxable account.
Note that you only owe tax on mutual fund income or capital gain distributions if you hold an investment inside of a taxable account like a brokerage account. By contrast, ongoing income and capital gain distributions from holdings inside of an IRA or 401(k) do not have any tax consequences unless you pull them out and spend them. Investors incur taxes on their traditional IRAs and 401(k)s when they begin pulling money out—not along the way, as taxable-account investors do.

Don’t: Sweat it if you are in the 10% or 15% tax bracket.
Not all taxable investors need to worry about mutual fund capital gains distributions, though. Investors who are in the 10% or 15% income tax brackets currently owe no capital gains tax on securities they have held for at least a year. Such investors might even consider actively selling highly appreciated securities in an effort to increase their cost basis.

Do: Know the warning signs.
Many funds have confronted a negative convergence of late: A strong market has boosted the value of their holdings, but investors have been redeeming their shares. That means that the manager may have to sell shares of stock—some highly appreciated—to pay off departing shareholders, and those gains, in turn, are distributed across a smaller shareholder base. Closed funds also frequently dish out large capital gains distributions to investors because it is much easier for money to leave than it is for new assets to get in the door. Manager changes are another major catalyst for selling and subsequent distributions as a new manager or comanager remakes a portfolio to his or her liking.

Don’t: Expect a previously tax-efficient fund to remain so.
Some investors might assume that if a fund has been tax-friendly in the past, it will continue to be that way. But tax-efficiency statistics tax-cost ratio are not necessarily predictive. Market performance certainly plays a big role—it is much easier for funds to limit capital gains if they have offsetting capital losses on their books, and it is harder for them to control capital gains once those losses are gone. Moreover, even funds with very low-turnover strategies and histories of few capital gains distributions may undergo fundamental changes that lead to larger capital gains distributions.

Do: Watch a fund company’s website for details on upcoming distributions.
Starting in November and picking up in December, fund companies begin to publish information on anticipated capital gains distributions. These are usually estimates and may change slightly on the distribution date, but you should be able to get some sense of whether your holdings will be making them and how large they will be. You will see the estimated distribution expressed in dollars-and-cents terms; divide that amount by the fund’s current net asset value to see how large a distribution is on the way. Impending distributions amounting to more than 10% of a fund’s NAV should set off alarm bells. Also, pay attention to the distinction between short- and long-term capital gains; the former are worse than the latter because they are taxed at your ordinary income tax rate.

Don’t: ‘Buy the distribution.’
It is debatable whether you should do anything if a fund you own is about to make a distribution (more on this below). But one thing is for sure: If you are considering adding a fund to your portfolio—or heavily bulking up an existing position—and a fund is forecasting a large capital gains distribution, consider holding off on your new purchase until the distribution has already occurred. Otherwise, you will be paying taxes on gains that you were not on board to enjoy.

Do: Make sure you are accounting for distributions you have reinvested.
You will pay taxes on a fund’s distributions in the year that you receive them, whether you reinvest that money or not. But if you are reinvesting those distributions, you can adjust your cost basis upward to account for them. Doing so effectively allows you to avoid paying taxes twice on that distribution. Mutual fund firms are now keeping track of customers’ cost basis; make sure you have elected the best method and that you are keeping cost-basis documentation for funds that you owned before 2012, when fund companies were required to start keeping track of clients’ cost basis.

Don’t: Assume index funds and exchange-traded funds are immune.
Largely because they do very little trading, broad-market index funds make regular dividend distributions, but sizable capital gains distributions have been few and far between. All bets are off when it comes to many other index fund types, however. Small- and mid-cap index funds, for example, may have to sell holdings that have appreciated beyond their target capitalization range, and that can result in at least some capital gains distributions. So-called strategic-beta funds also construct their portfolios based on a set of rules that can result in more frequent changes and lower tax efficiency than broad-market index products.

Do: Sell pre-emptively if you need to rebalance or wanted to sell anyway.
If a fund you already own is about to make a big distribution, there is one good reason to consider selling pre-emptively: If you planned to lighten up on it anyway, because it is consuming too large a share of your portfolio or if you no longer like its fundamentals. Yes, you will owe taxes on the difference between your cost basis (the price you paid for your shares) and the current share price; but if you sell before the fund makes its distribution, you will at least dodge the taxes due on the new distribution. Investors using the specific share identification method for cost basis might even unload their highest-cost shares, thereby reducing the tax hit on their sales.

Don’t: Sell pre-emptively to dodge a distribution without considering the other tax consequences.
That said, selling long-held funds pre-emptively does not often add up, because you may cost yourself more in taxes than you would pay on the distribution alone. The reason is that fund investors face two layers of capital gains taxes: the taxes they incur with their own buying and selling, as well as the taxes they owe on the distributions. So, you may dodge the distribution with a sale, but if your cost basis is below your sale price, you will owe capital gains on the differential.

Do: Look for offsetting losses.
If you are facing down large capital gains distributions, hunt around your portfolio for losses that you might use to offset those gains. Commodities, precious-metals, and energy-related holdings, whether funds or stocks, could be ripe for the picking; all are down sharply in the past three years.

Don’t: Reposition for tax efficiency in one fell swoop.
If you are disgusted by large capital gains distributions from your holdings, it might be tempting to initiate a tax-friendly makeover. Broad stock market exchange-traded funds, traditional index funds, and tax-managed funds all tend to be more tax-efficient than actively managed products. Municipal-bond funds limit the tax collector’s cut for fixed-income investors. But given the appreciation that most active funds have enjoyed over the past several years, investors will likely incur even larger capital gains as they sell to reposition for tax efficiency. If the current market volatility continues, investors may well have a chance to shed some of their tax-inefficient holdings at a later date, when prices are lower.


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