The holiday season is fast approaching, which means it’s nearly time for mutual funds to share some gifts with investors — namely, income and capital gains distributions.  So, let’s review the basics of “distribution season.”

At least once a year, mutual funds are required by law to distribute to shareholders any income, dividends and profits from buying and selling stocks, bonds or other securities (technically called capital gains) that have accumulated over the course of the calendar year. Most bond funds distribute income more regularly (they do this to replicate the experience of owning your own portfolio of individual bonds), but they, too, must address the capital gains question annually.

Distributions are taxed at different rates depending on the type. Income from interest and some dividends distributed from a mutual fund are treated the same as income you receive in a paycheck. (Obviously, tax-free interest income doesn’t count.) However, if a U.S. company stock is held for at least 61 days, its dividend becomes “qualified” and is taxed at a lower rate — either 15% or 20% depending on your tax bracket.

As for profits made from buying or selling positions, the IRS makes a distinction between positions the fund held for one year or less (short-term) and those held for more than a year (long-term). Long-term gains are taxed at the same rates as qualified dividends, while short-term gains are taxed at your regular income tax rate.

Funds can have both realized and unrealized gains. Say a portfolio manager buys a stock for $10 a share, which then rises to $15. That $5 is gain is considered unrealized until the manager sells the stock, when it becomes a realized gain. You are only taxed on the gains that are realized and then distributed to you — not the unrealized gains.

One other wrinkle to capital gains is that you can also have capital losses. If a manager sells a holding for a loss, this loss can be used to “offset” a realized gain — reducing the fund’s distribution to you, and your tax bill. These losses can also be “carried forward” from year to year to use against future gains. The silver lining of a bear market is that it provides an opportunity for savvy managers to “harvest” losses, which can then be used to reduce taxable gains in the future.

If you own a mutual fund in a tax-deferred account, like an IRA or a 401(k), then you don’t really need to worry about distribution season. Investors that are subject to taxes need to pay attention. If you buy a fund the day before it distributes its income and capital gains, you will owe taxes on the full years’ worth of gains, even though you weren’t there to benefit from them. This is called “buying a distribution” and in most cases, it’s something you want to avoid. Contrary to the questions I seem to get every year, buying a fund just before its distribution does not give you free money — but it might give you and your accountant a headache at tax time.

How do you know when a fund is distributing? Keep an eye out for a distribution schedule from the fund company.  Vanguard will be announcing theirs on November 11. Also, looking at when the fund distributed gains last year usually provides a decent guide for when a fund will distribute this year. If you are trying to trade to avoid buying a distribution, you need to be aware of a few dates: The first is the record date, which simply means that if you are a shareholder on that date, you will receive the upcoming distribution. This is different from the reinvestment or “ex-dividend” date, which is usually a day or two later and is when the fund’s NAV drops by the same amount as the distribution. If you are automatically reinvesting distributions, this is the price at which you will purchase more shares.

One additional piece of advice before turning to the tax factor: If you are a taxable investor, I have long suggested (and practiced in my own portfolio) that you direct distributions, whether income or capital gains, to a money market fund as opposed to automatically reinvesting. Directing distributions to cash allows you to set aside money for expenses and taxes or to rebalance a portfolio without having to sell shares and possibly generate further taxable gains.

Wagging the Tax Tail

Taxes are a cost, and I try to control all the costs in my portfolio. However, many taxable investors get hung up trying to minimize their tax bill when they really should be worried about their returns after taxes. The two don’t always go hand in hand.

Consider a taxable investor who bought $10,000 of Vanguard Dividend Appreciation ETF (VIG) the day the ETF launched (April 21, 2006) and only reinvested his after-tax distributions. (I used a tax rate of 35% for dividends and short-term gains and a rate of 20% for long-term gains.) If the investor received $100 in dividends, only $65 was reinvested back into the fund. At the end of September, this investor’s position would have grown to $17,255, and his total tax bill along the way was $710.

An investor who followed the exact same strategy using Vanguard Dividend Growth (VDIGX) would have paid $786 in taxes but grown her account to $19,134 through the end of September 2014. The investor in Dividend Appreciation ETF had the smaller tax bill, but the investor in Dividend Growth had a larger account after taxes.

So, yes, you should pay attention to taxes. Typically with a mutual fund, you as the investor can control when a taxable event happens by choosing when to sell your fund. The year-end distribution season is when a taxable event is forced onto shareholders. This isn’t something to dread or shy away from. If your fund is distributing gains, that means it’s booking profits. Be prepared for distribution season (it comes every 12 months), and keep an eye on the calendar so you don’t buy into a distribution. But don’t forget that the goal isn’t to avoid all taxes, but to have the most money after taxes.

Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won nine Best Financial Advisory awards from the Specialized Information Publishers Foundation.