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When it comes to investing, not all gains are good. Wait, what? That can't be right. But I'm not talking about investment gains; I'm talking about capital gains.

Most investors are familiar with the idea that they're taxed on what they earn: If you buy a security and sell it at a higher price, the difference is usually subject to a capital gains tax. But what surprises some investors is that it's possible to owe capital gains taxes even if you didn't sell the security at a gain that year. Why? Because mutual funds and ETFs can also distribute capital gains to their shareholders.

Capital gains in mutual funds and ETFs occur for the same reason they occur in investor portfolios - the fund has sold securities at a gain at some point during the year. Funds are required to distribute the proceeds to shareholders by December 31st every year.

The federal government currently taxes long term capital gains (from investments held more than 1 year) at 15%, and short term capital gains at an individual's ordinary income tax rate. These tax rates are, of course, the subject of some heated discussion in Washington right now.

Sounds like just another tax you don't have time to worry about, until you look at the numbers. Depending on how long the fund held the investment before selling it at a gain, you can pay a hefty bill. If a fund paid a $10,000 capital gain distribution to you, you could owe anywhere from $1,500 to $3,500 in taxes. Ouch.

Like any other tax, capital gains costs can erode your investment returns. So, what can you do about it? Two things:

1. Check out your portfolio now to see where you might be hit with a capital gain.

Fund companies tend to announce gains during the fall, and generally post gains on their websites so you know what to expect. Where should you look in your portfolio to see if you're about to be hit with a gain? There are a few places to be wary of this year, according to the data that we've collected:

  • The worst and most frequent offenders are US small- and mid-cap stock funds.
  • Based on current estimates, over $58 billion will be returned to shareholders.
  • About 4 in 10 funds that have announced estimates so far expect to pay out capital gains. Of those funds, 1 in 10 is expected to pay out more than 2.5% of NAV.

(click to enlarge)2. Take action before December 31, 2012.

When funds announce estimated capital gain payments, they're required to tell you when they expect to pay them. Most pay between November 1 and December 31, so this is cap gains prime time. If you find your fund is about to pay a capital gain, you can consider exiting the fund before the gain is paid in order to save on your total tax bill and keep more of your return. Depending on if you made or lost money on the investment, you may also benefit from tax gain or loss harvesting.

By the middle of December, more than 75% of estimated capital gains will have been distributed. By the time the ball drops in Times Square, the window of opportunity will have closed.

I don't know about you, but I'll take any help I can get when it comes to keeping more of what I earn. I don't want my gains to be in vain.

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