Most mutual funds are down for the year, but annual distributions may still create tax headaches for investors. But there is a way around it.

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If you were looking for another reason to dump a mutual fund this year, you might find it in your fund company’s annual estimate of year-end distributions.

Experts are unsure of just how bad the “distribution season” will be this year, some figuring that funds recognized a lot of their long-term gains while struggling through 2006 or 2007, while others figure that redemption pressure in ’08 forced managers to sell longtime winners.

But if distributions are about to make a bad situation worse, then fund watchers say it may be time to make a move before year-end distributions are paid out, thereby avoiding a tax headache and leaving behind a loser fund in one fell swoop.

Here’s how “tax harvesting” works for mutual funds, and why investors in taxable accounts may want to pay particular attention this year:

Mutual funds are “pass-through entities,” meaning that tax liabilities incurred holding or trading securities pass through the fund and on to shareholders. By law, funds must distribute at least 98 percent of the dividends and capital gains — profits made when investments are sold — that they accumulate during the year. Most stock funds make annual distributions in December, but estimate those payouts in mid- to late November. Typically, the projected numbers are available by phone or on the fund firm’s Web site.

A shareholder in a taxable account owes any taxes due on those distributions, even if the money is rolled back into the fund untouched.

As such, it is possible to owe taxes on funds that have a loss for the year. That’s almost a certainty this year, when more than 90 percent of all funds are currently in negative territory, and yet trading actions may have created a taxable “profit.”

For a long-term investor, here’s where the math gets tricky, but also telling.

Say you started the year with $5,000 invested in a fund that has year-to-date lost 20 percent of its value, meaning it is now worth $4,000. And let’s say it is about to pay a 10 percent distribution, or $400 of its current value.

You owe taxes on the $400, despite the beating you have taken in the fund. To avoid that, you could sell before the payout. The question, then, will be the sum total of your investments versus the current value of your account.

If you have a loss in the fund over the entire time you have owned it — rather than just this year — selling vaporizes the payout conundrum and captures a long-term loss.

The amount of that decline can be used to offset gains from other investments; if you have no other gains to offset, it can be used to neutralize up to $3,000 in income per year.

If, however, your account is profitable — the current year has only cut into growth seen over many years — then you must consider whether it is worth recognizing those long-term gains to avoid a current tax hit and make a change in your portfolio.

Be sure you factor past distributions into your math. Many investors figure they will take a big tax hit because they have held a fund for years; but if the fund’s growth has been through distributions and reinvestments, that money gets added to your direct deposits.

“Mutual funds are complicated when it comes to figuring out where you really stand with gains and losses, because you can lose money but still owe taxes in any given year,” said Rick Petrucci, of Baystate Financial Services in Boston, “but this is definitely the right time to be looking at tax harvesting and considering whether it works for you.”

Petrucci said that investors who take losses need to have a plan to keep their money working, and not just to beat Uncle Sam out of a few bucks.

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