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All mutual funds are required by law to distribute capital gains and dividends to shareholders annually, and, appropriately enough, this "gift" of income typically occurs around the holidays. Frequently, however, it's accompanied by a lump of coal: Even if you choose to reinvest the proceeds back into the fund, the distribution you receive is subject to taxation if held in a taxable account. Uncle Sam duns long-term capital gains at a 20% rate, while short-term gains (i.e., gains realized on stocks held less than a year) and dividends are taxed as ordinary income.
In 2002, however, only the lucky few will have to worry much about paying taxes on realized mutual fund gains. Nearly all domestic-equity funds, for instance, are looking a lot like Santa Claus lately--they're deep in the red. True, funds sometimes pay out capital-gains distributions in years they've lost money. In 2000, for example, many aggressive-growth fund shareholders took it on the chin from both Uncle Sam and the market when their funds' managers took profits on stocks they'd held during the runup of the late '90s.
That's likely to be less of an issue in 2002, however. At the end of October, the average domestic-equity fund had potential capital-gains exposure of -48% of assets, meaning the typical fund is carrying a substantial loss on its books. Moreover, mutual fund managers are allowed to hoard their losses for later use. These "tax-loss carryforwards" can be used to offset gains made elsewhere in the fund for up to seven years after the loss occurred.