The tax hit that loyal investors will take in 2014

If you are the kind of steadfast investor who buys a mutual fund and holds it forever, prepare to pay for your loyalty next April, when you settle up your 2014 tax bill.

At the end of this year, many mutual funds are expected to distribute sizeable capital gains to shareholders who will have to pay taxes on them.

That is true of stock mutual funds that sold off last week after carrying forward big gains from 2013, and also may be true of the popular Pimco Total Return Fund, which was thrown a curve when star manager Bill Gross left Pacific Investment Management Co in late September and the Pimco Total Return Fund was forced to sell appreciated bonds to pay off shareholders who left in his wake.

Here is why: Mutual funds must distribute realized gains to their shareholders every calendar year. Managers of both bond and stock funds have seen sizeable gains for several years running, but have not had to sell shares and realize those gains. This year, there have been some big selloffs that may have forced the managers to sell winning securities and realize those gains for tax purposes.

For individual investors, those gains might hurt more than they would have over the last few years, because a lot of investors have been offsetting their taxable gains for years with losses they carried over from the 2008-2009 rout. Now, with most of their losses used up, they will have full exposure to the gains. Long-term gains are typically taxed at 15 percent; those in the top tax bracket face a capital gains tax rate of 20 percent.

The Pimco Total Return Fund, for example, saw $48.4 billion in outflows through September, according to data from Morningstar and Pimco, and some analysts believe that could result in unusually high taxable gains.

"If PIMCO sold bonds to meet redemptions at a gain, the remaining shareholders could suffer an inordinately large tax consequence," said Tom Roseen, an analyst with Lipper, a Thomson Reuters company.

Through September, research firm Morningstar was estimating that Pimco Total Return Fund would pay out 2 percent of its net asset value in taxable gains, a high figure but one not out of the fund's long-term historical range.

That means a person with $50,000 in that fund would see a $1,000 taxable gain, and - at the most common 15 percent capital gains tax rate - owe $150 in federal taxes on it.

Last year, the Total Return fund distributed 0.66 percent net asset value in gains. The year before, it distributed 2.31 percent, Roseen said.

Stock fund investors could be harder-hit, said Morningstar analyst Russel Kinnel. He estimates that U.S. domestic stock funds might be sitting on gains of around 20 percent and could end up paying 16 or 17 percent of their value to shareholders as gains. (When that happens, fund shareholders do not actually cash in the gain; they end up with more shares at lower prices.)

Note that none of this affects investors who hold mutual funds through tax-favored retirement accounts. They do not have to pay annual taxes on fund earnings.

For everyone else, there are very few ways to minimize the impact of those taxable gains. Here are some strategies that might help.

- If you bought recently, you might consider selling quickly. If you have not seen much of a gain in a fund you bought, or if you have actually sustained a loss, you can sell shares and either use your capital loss to offset other gains, or at least get out before the gain is distributed. That strategy will not work if you have been in the fund long enough to rack up your own gains - then you will just have to pay taxes on them when you sell.

- Think before you buy. The people who will get hardest-hit by these year-end mutual fund taxes are people who have not owned the funds for long. They buy in just before the distribution, miss out on the actual gains, but get hit with the taxable distribution anyway. Do not buy any funds this year until you have checked with the fund company to find out when it is distributing 2014 gains. If you think it is a fund that is sitting on big gains, wait until that date passes before making your purchase.

- Take losses. If you own any stocks or funds that have lost money since you have held them, sell and reap the loss. It can offset those fund gains.

- Relax. At 15 percent for most people (20 percent for top tax bracketeers), the capital gains tax is still much lower than regular income taxes. And there are worse things than having to pay taxes because you made money.