Mutual Fund Investors, Beware: A Scary Tax Bill Is Coming

The taxes you pay on your investment gains are among the biggest drags holding back the growth of your portfolio. Fortunately, many investors in stocks, bonds and other types of assets have almost complete control over when they pay taxes on their hard-won profits. For mutual fund investors, though, the end of the year is always a dangerous time on the tax front, and this year, the risk of a big tax-bill surprise looms larger than ever.

Why Mutual Fund Investors Have to Worry

Most investors benefit from Internal Revenue Service rules on capital gains that give them considerable flexibility on reporting profits on their tax returns. With most stocks and other common investments, you only pay taxes on capital gains when you sell your shares. So for buy-and-hold investors who prefer to own stocks for years and even decades, taxes are rarely an issue, and as long as you're comfortable holding on to your shares, you can defer taxes as long as you want.

%VIRTUAL-WSSCourseInline-734%With mutual funds, though, taxes are trickier. Even if you hold on to your mutual fund shares, you can still owe capital gains taxes. That's because of a special way the IRS treats mutual funds: When the fund sells some of its holdings at a gain, it has to pass through the taxable income to shareholders in the form of a taxable year-end distribution.

Many investors choose to reinvest those distributions into additional shares of the fund. But even if you never see any cash from a capital gains distribution, the IRS nevertheless treats it as taxable income that you have to include on your return.

Why 2014 Could Be Especially Bad

Until recently, most mutual fund investors didn't have to worry much about capital gains distributions. The reason: Many funds had considerable losses on their books from the market meltdown in 2008, and even as the stock market recovered, funds used those past losses to offset newer gains.

Unfortunately, most of those losses have run out, and now, capital gains distributions are likely to be on the rise. Adding to the potential problem is the recent turbulence in the stock market, which has encouraged some fund managers to sell off winning stocks to lock in gains rather than face the prospect of further losses.

The tax hit investors will see in 2014 could be massive. Fund-research company Morningstar believes that huge gains could get distributed to fund shareholders this year, with analyst Russel Kinnel estimating as much as 16 percent to 17 percent of fund value paid out as taxable gains. For an investor with $10,000 in a fund, a distribution of $1,600 would translate to an additional tax bill of $240 to $320 or more -- without necessarily seeing one penny extra.

What You Can Do

If you already own mutual fund shares in a taxable account, then there isn't a lot you can do to avoid those taxes. In some cases, selling before a distribution can lead to a smaller tax bill. But if you've been invested throughout the rise in the market over the past five years, then it's likely that you'd have just as big a tax hit if you sold out than if you held on and received a year-end capital gains distribution.

What you can do, though, is to avoid putting any new money into your mutual fund until after it pays out its year-end distribution. That way, you'll end up buying shares at a cheaper price and getting more of them, rather than buying fewer, more expensive shares but immediately getting a distribution back to keep or reinvest.

In addition, if you want to use mutual funds, keeping them in individual retirement accounts and other tax-favored accounts can be the best way to avoid tax problems. Within an IRA, 401(k), or other qualifying retirement account, mutual-fund distributions don't result in any extra tax on your tax return.

In the past, lawmakers have considered changing tax laws to allow those who reinvest their distributions in additional shares to defer any capital gains tax liability. So far, though, those efforts have come to nothing, and so mutual fund investors need to keep their eyes on any announcement their fund companies make about year-end distributions and take the appropriate action to minimize what taxes they'll have to pay.

Motley Fool contributorDan Caplingerlearned about mutual fund taxes the hard way. You can follow him on Twitter@DanCaplingeror onGoogle Plus. To read about our favorite high-yielding dividend stocks for any investor, check outour free report.