November isn't over yet, but it's none too early to be thinking about tax time. Every December, mutual funds distribute their capital gains for the year to shareholders, and Vanguard funds are no exception. Many shareholders panic at the resulting drop in net asset value or end up paying taxes on money they just invested. You need to understand what's really going on and how to prepare for it.

The key is knowing where capital gains distributions come from. When mutual funds sell securities for a profit, the capital gains have to be given to shareholders. This is usually done in December after all the realized gains for the year have been tallied.

Up until the December distribution, the mutual fund's share price includes any undistributed capital gains. So when the distribution finally comes, the share price drops by the amount of the distribution. That doesn't mean shareholders have less money. It just means some of it has been converted to cash or, if reinvested, additional shares in the fund. So if you see your fund's net asset value drop suddenly one day in December, don't panic. It's what happens after a distribution.

Unfortunately, capital gains are taxed to the fund's shareholders regardless of when they bought their shares. That means if you invest the day before the distribution, you still have to pay taxes on all the gains the fund made during the year before you bought shares, even though you don't have any more money than you started with. So you should never invest large sums of money just prior to a distribution.

The good news is you can avoid unpleasant surprises like these by taking a look at expected capital gains distributions for your mutual funds. I do this every year with all of the Vanguard mutual funds and report it to my newsletter's subscribers as soon as I've got the estimates together. Here are the expected top 5 gainers at Vanguard, expressed as a percent of net asset value:

Now, remember two things. First, just because you shouldn't buy before a distribution doesn't mean you shouldn't own a fund at all. Wait until the distribution is out of the way so you can buy shares without an unnecessary tax penalty.

Second, just because a fund is making a big distribution doesn't mean it's the best fund to own. Losing funds can still generate capital gains, and good funds can avoid big capital gains with good tax management. I'll tell you more about tax efficiency and how to distinguish the best funds in my next blog entry.