December's arrival means tax season for many fund investors

December's almost here, which means many fund investors are about to get a taxable lump in their accounts.

The end of the year is distribution season for mutual funds and exchange-traded funds. That's when funds send payments to their investors called capital-gains distributions, and shareholders receive them even if they don't sell any shares. These distributions can be as big as 20 percent of a fund's price, and investors holding funds outside a 401(k), Individual Retirement Account or another tax-advantaged account can be liable to pay capital-gains taxes on them.

Funds have already put notices on their websites to give shareholders an idea of what to expect. The biggest mutual-fund family by assets, Vanguard, expects to send gains distributions for several dozen of its funds in late December, for example, running the gamut from a health care stock fund to a New Jersey municipal bond fund to a dividend stock fund.

A confluence of several, disconnected factors is pushing distributions higher this year, from investors' continued march to index funds to the rash of buyouts that has occurred in recent months.

Capital-gains distributions are a result of trades that funds make through the year. When a fund sells a stock, it records how much it made or lost on the investment. At the end of each year, the fund tallies up all the gains made and passes them on to shareholders as a capital-gains distribution.

When that happens, the price of the mutual fund drops by the same amount. So, if a fund trading at $50 passes along a $5 capital-gains distribution, its price drops to $45. Shareholders still have $50 worth of investments but have to pay capital-gains taxes on the $5, if the fund is held in a taxable account.

Funds that make a lot of trades in a year have bigger gains distributions than those that hold investments for the long term. A special class of funds, called tax-managed funds, tries to limit their trading in hopes of minimizing these distributions. Index funds also tend to have less because they do less trading.

The recent flurry of corporate takeovers has also triggered some gains: October saw a record amount of U.S. mergers and acquisitions announced for a month, highlighted by AT&T's $85 billion deal for Time Warner. When a stock in a fund's portfolio gets taken out, it automatically triggers a gain.

With that in mind, here are several factors to stay mindful of this distribution season:

— Watch out for funds with shrinking assets or new managers.

When a mutual fund's size is shrinking — and its shareholders are fleeing — its managers need to raise cash to return to them. They do that by selling stocks or bonds, and those transactions can trigger capital gains. The S&P 500 is at a record high and closing in on its sixth year of gains in the last eight. That means funds are likely booking gains when they're making any sales.

Exacerbating things for some funds run by stock pickers is the rise of index funds. Investors are increasingly opting for the lower costs offered by mutual funds and ETFs that merely track market indexes, rather than try to beat them. Nearly $40 billion went into index funds during September, for example, while nearly $23 billion left actively managed funds, according to Morningstar.

Those departures further force funds led by active managers to sell stocks and bonds, triggering more gains.

In a similar vein, when a new team of managers takes over an actively managed fund, they often turn over the portfolio to bring in their favorites and excise the old regime's.

— Don't think you're immune if you're in an index fund or ETF.

Index funds and ETFs are certainly more tax efficient than funds run by active stock pickers, but they can also pass along distributions. Indexes change over time, and funds have to make purchases and sales to continue to match the index.

Some specialized ETFs can also have distributions, such as those that invest in foreign stocks but try to eliminate the effect of shifting currency values. These ETFs "hedge" against currencies by trading financial derivatives, and these deals can lead to gains distributions.

Of the 21 ETFs where iShares expects to make a gains distribution later this year, 10 are currency-hedged funds, for example.

Capital-gains distributions for index funds and ETFs, though, tend to be small and rare in general.

— If you're looking to buy a fund, it can pay to wait.

If you buy a fund for your taxable account just a few days before the distribution is made, you have to pay taxes on it, even though you weren't part of the fund when the trades that triggered the distribution occurred.

So if you're interested in a fund for your taxable account, waiting just a few days to purchase it can mean avoiding a bill. Likewise, if you're planning on selling a fund that's in a taxable account, it can pay to do so before the record date for its capital-gains distribution.