Every year, mutual funds buy and sell stocks or bonds. If they wind up with profits on those sales, those profits are subject to tax.
Mutual funds don’t have to pay income taxes on their capital gains, however, if they distribute those gains to shareholders at least once a year. Most funds make these annual distributions in December. The distributions are taxable to shareholders as if the shareholders themselves had made the underlying profits.
Thus, an unsuspecting shareholder who buys into the fund the day before the distribution will find that his purchase price includes all the profits that are still in the fund. If he’s hit with a distribution one day later, the tax law treats it as a taxable capital gain, even though it’s really a return of capital. Before investing late in the year, call to find out if a capital gains distribution is planned, then buy after the distribution.
