We've already talked about the tax implications of your mutual fund share transactions. Another type of tax liability comes from distributions by the fund to the shareholder in the form of dividends, interest and capital gains.

A mutual fund must distribute all income and net realized gains to its shareholders. (Realized gains and losses result when the fund sells securities; unrealized means the securities are still held by the fund.) These distributions can have an impact on your tax liability as well as the share price of the fund.

• Income dividends include any interest, dividends or short-term capital gains earned by the fund from the securities in the portfolio, after fund expenses are deducted.
• Capital gains distributions are usually made annually to mutual fund shareholders. They result from profits on the sale of portfolio securities after deducting any losses. When a distribution is made to shareholders, the net asset value of the fund drops. By reinvesting capital gains, you can increase the number of shares in your account.

A fund's net asset value (price) will drop by the amount of a distribution -- whether a regular income dividend or a capital gain payment. Shareholders who reinvest their distributions will receive additional shares. Shareholders who receive their distributions in cash must remember that the distribution remains part of their investment's total return -- the combination of income or gains received plus any increases or decrease in share price over a given period.

While a fund may not know the exact date or amount of an annual income or capital gains distribution far in advance, they do usually know the approximate amount and date. Most such distributions occur near year end. Therefore, if you are planning a substantial investment in a fund near year end, you may wish to contact the fund group and inquire about potential distributions. If a large one is anticipated, you may want to invest after the "record" date to avoid the tax liability.