Often, they are able to minimize capital gains taxes by selling stocks with gains and losses in the same year, using the losses to offset the gains for tax purposes. But with mutual funds, investors lose this flexibility, because fund managers decide when and how to realize gains and losses. When managers sell stocks owned by a mutual fund for a gain, the fund itself does not pay capital gains tax on them. Instead, the gains are passed through to those who invested in the fund. They must then pay taxes on such gains, even if they never sold any of their mutual fund shares and had all gains reinvested.
Investors can minimize their tax bite by investing in tax-efficient funds.
In general, these are mutual funds that buy and hold stocks, rather than trading them frequently. Index funds, which track things such as the Standard and Poor's 500 index, tend to be among the more tax-efficient funds. But even here, there can be significant differences in the tax liability of investors, depending on which mutual fund company's index fund they bought. Unfortunately, in recent years, fund managers have tended to become more and more active in their management of fund portfolios. Stock turnover among mutual funds, which historically averaged about 17 percent per year, has risen to 90 percent.