Investing in a taxable account in December can mean paying the taxman, writes John Heinzl, reporter and columnist for Globe Investor.

I recall reading that it is generally not desirable to buy mutual funds near the end of the year because of distributions that are taxable to unitholders. Is that also true of exchange-traded funds? Do investors who receive these distributions actually receive any financial benefit?

Mutual funds and ETFs typically distribute capital gains in December, and investors must pay tax (at half the rate of regular income) on these amounts. Problem is, if you buy the fund shortly before the distribution is declared, you'll be required to pay the taxman, even though you didn't own the fund while it was earning those gains during the year.

Let's look at an example, which I've shamelessly lifted from the Canadian Securities Course textbook. Keep in mind, this is only an issue if you're investing in a taxable account; if you hold your funds inside a registered retirement savings plan or tax-free savings account, the question is moot.

Also, we're talking here about capital gains distributed at year-end, as opposed to dividends and interest, which are typically distributed throughout the year.

Okay, assume you buy a mutual fund with a net asset value (NAV), or price, of $30. We'll also assume the fund manager made some great stock picks during the year, and the fund has $6 in net capital gains (capital gains minus capital losses). A few days after you buy the fund, it declares a $6 distribution.

Whoopee! An easy $6, right? Not quite. When that $6 goes out the door, the fund's NAV will drop by an identical amount. The units will now be worth $24, and you'll have $6 in distributions. Put the two together, and you're back to the $30 you originally invested-so you haven't actually lost or gained anything.

Except for one small problem: You have to pay tax on the $6 distribution, regardless of whether you take it in cash or reinvest it. If you have a marginal tax rate of 40%, for example, you'll owe the taxman $1.20 (40% of $3 . remember, only half of the $6 capital gain is taxable).

Bottom line: You'll end up with $28.80 ($30 minus $1.20).

Now, you could have avoided the immediate capital-gains tax hit if you'd bought the fund after the distribution was paid, or in the case of ETFs, on or after the ex-dividend date. In that scenario, you'd still have the original $30 you started with because there's no distribution, and no immediate tax to pay.

"A lot of people.blindly jump into these things at year-end and get burned," said Philip Lee, senior fund analyst with Morningstar Canada. To avoid unexpected taxes, he recommends that investors ask the fund company whether there are any year-end capital gains distributions pending.

"It's hard, because you can't really go on history. It's really a function of market conditions. So the best thing to do is contact the fund company."

ETFs also typically distribute capital gains in December. An ETF's capital gains can arise from a variety of sources, including changes in index constituents (when a company is taken over, for example), sales of securities, and profits on currency hedging.

To give investors a heads-up, every November, ETF providers including iShares and Claymore publish the dates and estimates of the annual capital-gains distributions for each of their funds.

"Clients are definitely mindful that it's something they should be aware of, and that's part of the reason we put the estimates out," said Steven Leong, vice-president of iShares product development at BlackRock Canada.

Waiting until after the distribution seems like such an easy way to avoid tax that there must be a catch, right? Well, sort of.

The truth is that, assuming no change in your marginal tax rate, you're effectively just kicking your tax obligation down the road, because the lower NAV post-distribution will give rise to a larger capital gain-or smaller capital loss-when you ultimately sell your units, said Jamie Golombek, managing director, tax and estate planning, with CIBC Private Wealth Management in Toronto.

But given the choice between paying $1 in tax today or $1 five or ten years from now, most people would choose the latter. "Really it's a deferral opportunity," he said. "No one wants to pay tax before they have to."

That said, tax should not be the only consideration when purchasing a fund, Golombek said. By waiting until after the distribution, you could miss out on market gains that would more than outweigh the benefits of delaying the tax.

[The advice given above was addressed to Canadian investors. US securities laws may vary. If you are unsure about your tax liability, contact a professional advisor or tax specialist-Editor.]