Many fund investors will get an unpleasant surprise from their tax preparer this year, a bill for the distributions they got from their...

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Many fund investors will get an unpleasant surprise from their tax preparer this year, a bill for the distributions they got from their funds, even though those funds may have had a disappointing year.

Year-end numbers for 2007 are not available yet, but it is clear that distributions will amount to a record of more than $500 billion. You read that right: a half-trillion dollars, nearly $100 billion more than in 2006.

That means that one out of every $23 invested in funds today was recycled, passed back to the shareholder and, in most cases, back to the fund, creating a tax liability along the way.

By the time final numbers are available, investors with taxable fund accounts will have paid Uncle Sam more than $25 billion for the privilege of playing buy-and-hold in 2007.

If the tax bill makes you angry, it may be time to change your portfolio.

To see why, you must first have a clear understanding of how funds are taxed.

Mutual funds are “pass-through” securities, meaning that tax obligations pass through the fund and on to shareholders, who are on the hook for their share of taxes due.

Funds must distribute virtually all capital gains realized from trading securities, so an investor who holds a fund that trades in a taxable account can get slugged with a heavy tax bill each year. Shareholders must pay the tariff even if they never touch the distribution and simply reinvest the payout.

There are worse things than receiving taxable distributions, such as losing money. But in 2007, many funds with mediocre performance or losses wound up selling long-term winners to lock in profits, and the resulting tax bill is a kick in the pants to top off a bad year.

“People don’t see the problem because performance and taxes are disconnected,” says Tom Roseen, senior research analyst for Lipper, which compiles distribution data on funds. “Their year-end statement showed a return of 7.73 percent [the average for a domestic equity fund in 2007] and they thought ‘I did OK, even though the market wasn’t very good.’

“So they don’t realize how big a drag taxes were on their returns, or that the taxes basically took from 1.3 to 2.2 percentage points right off the top of their return. … Only when the tax bill is high do they, maybe, get upset about it.”

Many investors hold funds indefinitely, not wanting to pay taxes on the sale. But if you own a fund that generates big annual tax bills, those gains are taxed annually; so dumping the fund may not generate a tax bill and, in some cases, can create a loss, which has an actual tax benefit.

“If this keeps happening to you, then chances are you have paid for your gains annually, so you can get out and look for something more tax-efficient,” says Pat Goodall, editor of the No-Load Portfolios newsletter.

Most fund companies provide shareholders with their cost basis, the average cost per share paid to buy the fund. Investors should compare that price with the share price to see what kinds of gains hit they might face if they make a change.

Chuck Jaffe is senior columnist at MarketWatch. He can be reached at cjaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.