December is here, which means in addition to finishing your holiday shopping, investors need to think about and plan for capital gains distributions if they hold mutual funds. The end of the year is distribution season for mutual funds as they are required to distribute to shareholders their portion of capital gains and dividends incurred during the year. Shareholders are thus hit with a taxable gain, even if they have not sold any shares of the mutual fund. These distributions can sometimes be quite large, maybe even as much as 10-20% of the fund’s net asset value or NAV.

Capital gain distributions are a result of trades that mutual funds made during the year. When a fund sells a stock or bond, it records how much it made or lost on each trade and at the end of the year it tallies up all of its gains and this total is passed on to the shareholders in the form of a capital gains distribution. Depending on how long the fund held the security, the gain could either be a short-term or a long-term capital gain.

When the capital gains distribution is paid out, the price of the mutual fund drops by the same amount. So for example, if a mutual fund is trading for $10.00 per share and pays out a capital gains distribution, of $1.00, its fund price will then drop to $9.00 per share. If the fund is held in a taxable account, then the investor will be liable for a capital gain of $1.00/share. If 1,000 shares were held then the total capital gains would be $1,000. This tax liability would be due despite the investor not making any transactions themselves.

Funds that make a lot of trades during the year would tend to have higher capital gains distributions. Actively managed funds thus tend to generate more capital gains thus making them less tax efficient than passive funds, which don’t trade as often as they are more designed to replicate a particular index or asset category.

If you’re looking to buy a new fund or even add to an existing fund this time of year, you should check to see if they have already paid their distributions or know when they expect to pay it before your purchase. Even buying a fund the day before a distribution will have you incur their full year capital gain distribution, though you didn’t actually own the fund when they made their earlier trades. That way, you can avoid the extra tax liability.

Funds that pay out larger capital gain distribution that are less tax efficient should be held in a qualified account such as an IRA. Inside the IRA, the capital gain distributions don’t matter as the investor is not taxed on their yearly gains, but instead only pays taxes when they withdraw money from their IRA at some point in the future.

Minimizing taxes is one way to increase long-term returns, as net returns are based on how much you can retain after taxes. Being careful about fund selection, timing of fund purchases and placement of less tax efficient funds into IRAs can all help to minimize taxes, thus boosting your net returns.