You miss potential stock market gains if you wait to buy funds that pay out taxable gains this month. By Steven Goldberg, Contributing Columnist December 11, 2007 This is the time of the year when virtually every financial media outlet, including Kiplinger's Personal Finance, warns against buying stock funds that are about to pay out taxable gains. Buy funds in December, they admonish, and you'll end up paying taxes in April. Better to wait until the fund has distributed capital gains (see Year-End Investing Moves to Avoid).I take a different view. I think investors are better off buying funds now despite the tax bill -- even though many stock funds are paying out larger-than-usual capital gains this year. Of course, no one likes to pay taxes, and it usually makes sense to pay taxes later rather than sooner. But your tax savings are so tiny as to be largely illusory, and by delaying your investment, you miss potential stock market gains. What's more, no matter who wins the 2008 elections, I'd bet on the long-term capital gains rate rising. The real choice, unfortunately, is between paying less in taxes now or paying more later. Advertisement Let's start with the basics. During the year, mutual funds sell securities -- some for gains, some for losses. Late in the year usually, the fund tallies up its losses and gains on those trades and computes its net loss or gain. If it's a loss, the fund can carry it forward to the following tax year. If it's a gain, the fund must pay it out to investors, who, in turn, pay taxes on those gains. The 2000-2002 bear market left many stock funds with huge capital-loss carry-forwards. Funds used those losses to offset capital gains generated in more-recent years. But a five-year-plus bull market has exhausted those leftover losses for almost all stock funds. Funds paid out large capital-gains distributions last year and are doing so again this year. Here's what drives investors nuts: If you own a fund in a taxable account when it pays out its capital gains, you owe taxes-- no matter when you bought the fund. A fund may have held a winning stock for many years. But if the fund sold that stock this year and you bought the fund in December, more often than not you get stuck with the taxes. But what many investors and financial journalists overlook is that when a fund pays out capital gains, it adjusts its share price to reflect that payment. Thus, whenever you sell your shares in the fund, you recoup the tax losses you incurred this December. Advertisement Ah, but the experts counter, it's always better to pay taxes later rather than sooner. After all, so long as your money is invested -- rather than in the hands of Uncle Sam -- you can earn a profit on it. A gain in a fund's price on which you haven't yet paid taxes is, in a sense, like an interest-free loan to you from the Treasury. That's hard to beat. Over the very long term, delaying paying capital gains taxes, indeed, can make a significant difference in your investment returns. If you buy, say, a fund that mimics Standard & Poor's 500-stock index, such as the Vanguard 500 Index fund (symbol VFINX) and hold it for 20 years, you'll come out substantially ahead of an investor in an actively managed fund that achieves identical pretax returns. That's because the index fund rarely trades and pays out relatively little in capital gains. But most of us don't hold funds anywhere near that long. And even if we did, the average fund dribbles out capital gains every year. Few funds are as tax friendly as broad-based index funds. Advertisement What would it cost you to buy a fund two weeks before it pays out a distribution equal to 10% of assets? I had Vanguard run the numbers. On average, an ordinary fund returns 10% annually. (This exercise assumes you gain a smidgen of that return by investing two weeks before the distribution.) Of the annual gain, about 2% is paid out in dividends every year. Roughly 3% is paid out annually in long-term capital gains and 1% in short-term capital gains. I assumed a marginal combined federal and state tax income rate of 33%. Compare taking the tax hit now to buying after the distribution and holding the fund for three years -- about the average holding period for a stock fund. The difference in returns is 0.14 percentage point per year -- or a total of $47.39 on a $10,000 investment over the three years, according to calculations by Vanguard. Over five years, the difference is 0.07 percentage point per year-or a total of $69.60 over the five years. The point is this: The time value of money is worth very little unless you hold onto to an untaxed security for a very long time. And given that the stock market goes up about 70% of the time, there's far more risk to your financial well being from delaying purchase of a stock fund purchase and being out of the market. Advertisement The final factor to consider is the tax rate. At 15% for most taxpayers, long-term capital gains tax rates are low by historical standards. If the Democrats win the White House and retain control of Congress in the 2008 election, there is a strong chance that they will raise capital-gains tax rates. "Most of the Democrats are happy to see the capital gains rate go from 15% to 20% or 25%," says Bill Miller, manager of Legg Mason Value Trust. I think you can take a rise in capital-gains taxes to the bank. Steven T. Goldberg (bio) is an investment adviser and freelance writer.