In a perfect world, the typical mutual fund would have increased in value by 12% and thrown off capital gains dividends of, say, 12% this year. This, of course, is purely hypothetical and the fact is that the world in 2008 has been anything but perfect. In fact, if you are not careful, you may be in for a huge surprise when you receive your mutual fund tax statements.

Try this on for size. One large fund that has lost 55% of its value from the beginning of the year is looking at a capital gain distribution of almost 19% of its current market value. If you invested $20,000 in this fund on January 2, 2008, it would be worth $9,000 today and you would be paying tax on income of $1,710 (or 19% of $9,000). Does that make sense?

This nightmare is facing millions of investors as the year ends – and it’s precisely because of the major market downturn in 2008. Here’s how it happened. Over the years, your mutual fund has made various investments and, until this year, has probably seen a good run-up in the value of those holdings. Then, in October 2008, the market dropped like a rock and investors fled to the “safety” of cash and government securities by selling their mutual fund shares.

Where do you think the mutual funds got the cash to redeem those shares investors sold? That’s right, the funds sold investments - in appreciated stocks - and that created capital gains for the investors who held and did not sell. The only thing mutual funds can do now, with that “income” they realized, is distribute it to current fund participants, essentially creating phantom income.

That’s the bad news. The good news is that your mutual fund probably has published information on its expected capital gain dividend and you have until the end of the month to limit any damages, so let’s take a look at your alternatives.

The Big Easy

Without question, the easiest thing for you to do is nothing. If the fundamentals of your mutual fund are good and the tax hit you are looking at is minimal, it may make little sense to try and offset the gain. Bear in mind also that any gains inside qualified retirement plans have no effect on your taxable income - until you receive a distribution.

The Quick Fix

If you have no sentimental attachment to your fund or it’s not fundamentally a good fund anymore, now may be the time to unload it. The loss you realize on the sale of the fund will reduce or eliminate any capital gain dividend and will free up your money to make better investments.

Dump Other Dogs

Now is an excellent time to take stock (no pun intended) of your portfolio. If you are like many investors, you have stocks that simply have not met your performance goals in recent years. If those investments are presently in a loss position, you might consider selling them and harvesting the losses. You can use the loss realized to reduce or eliminate the impact of the capital gain dividend distribution from your mutual fund and then invest in more attractive alternatives.

Don’t Do This

If you are looking at hefty capital gains dividends on mutual funds in which you have a loss, but don’t want to get out of the securities for long, don’t think that you can sell the shares, record a loss and then repurchase them. Long ago, Congress recognized this temptation and enacted “wash sale” rules. Simply put, if you sell a security and buy it back within 30 days, the loss cannot be recognized. The risk, of course, if you sell and wait the required 30 days, is that the shares may have increased in value during those 30 days.

Conclusion

Many investors are looking at a surprise when they receive their 2008 investment statements. While the value of your portfolio may well have dropped, that does not mean you have escaped taxable income for the year. Call your investment advisor to determine if you have any surprises coming your way. Then, let’s get together to take a look at your alternatives.

Have a joyous holiday season.