Points to know

• At least once a year, funds must pass on any net gains they've realized.
• As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

Funds buy & sell too

Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain."

But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares. By law, the fund must pass on any net gains to shareholders at least once a year.

What happens when a fund passes on gains?

This could lead to several scenarios that might surprise you.

• In a down market, shareholders often take money out of funds, meaning the fund manager has to sell some of a fund's holdings to meet demand. If the fund sells lots with large built-in gains, this could lead to net gains, which you'll be taxed on—even if your fund's share price went down during the year.
• Also, you might buy shares of a fund that realizes capital gains soon after your purchase—in which case you'll owe taxes on these gains even if you haven't been invested long enough to benefit from them.
• On the flip side, capital gains are considered to be short-term or long-term based on how long the fund held the securities being sold. So even if you recently bought into the fund, you'll pay the preferential long-term capital gains rate (as long as the fund held the securities for more than a year).

The bottom line

If taxes are a concern for you, it's a good idea to look into a fund's unrealized capital gains before investing a large amount and to find out whether a capital gains distribution is imminent.

You also may want to consider investing in index funds, which tend to buy and sell less often, leading to fewer realized gains and losses.