Periodically, mutual funds make payments to shareholders representing their share of the interest, dividend, and capital gain income earned by the fund. These payments are called "distributions." If you're not careful in accounting for these distributions, you could pay more federal and state income taxes than necessary when the fund shares are eventually sold. (Of note, this article applies only to those investing through a taxable account. If your funds are held in an IRA or other retirement account, fund distributions won't affect your tax situation at all.)

A capital gain is the profit that results when you sell an investment for more than you paid for it. Many fund investors assume that the way to calculate the amount of their capital gain is to always subtract the amount they paid for their shares (their cost "basis") from the proceeds they received when selling them. This is true only in the simplest instance — where you bought all your shares at the same time, received no distributions while you owned them, and sold them all at the same time.

However, if you receive distributions, acquire your shares over time (for example, through dollar-cost-averaging or reinvesting your dividends), or sell only part of your holdings, there is more work to be done. Let's look at the most common situations.

• When you receive a distribution. Keep in mind: you aren't really gaining anything when you receive a distribution because the amount of the distribution is deducted from the value of your shares. For example, assume you buy 100 fund shares at $8.00 each. Your total cost is $800. The value grows to $12.00 per share, and your investment becomes worth $1,200 (100 shares multiplied by $12.00 each). If a $1.00 per share dividend distribution is declared, you will receive a check for $100 (100 shares multiplied by $1.00).

However, on the ex-dividend date, the value of your shares immediately drops to $11.00 because $1.00 per share has been taken out of the fund's assets to be mailed to shareholders. You haven't gained; you still have $1,200 in value — $1,100 in fund shares (100 shares multiplied by $11.00) and $100 cash. The fund has merely "robbed Peter to pay Paul."

The tax consequences work like this. If you had sold your shares before the fund distribution, you would have a $400 capital gain ($1,200 proceeds minus $800 cost). If you sell your shares after the distribution, you would have a $300 capital gain ($1,100 proceeds minus $800 cost) plus $100 in dividend income; thus, you still have total taxable income of $400. Selling after the distribution didn't change the amount of your profit; it only changed the tax nature of your profit.

• When you reinvest your distributions. If you have your fund distributions reinvested in more shares, you must be careful to avoid double taxation. When calculating your tax liability, you should add the cost of the additional shares purchased with your distribution proceeds to the amount originally invested in the fund. This will raise your tax "basis" in the fund shares you've acquired. In this way, you'll avoid being taxed twice — initially on the distribution and again later as a capital gain when the fund shares are sold.