This can cause a problem — especially if the shareholder has specified reinvestment of dividends and capital gains distributions from the fund. In that case, the income received by the shareholder is 'spent' to buy additional mutual fund shares. So how does the shareholder pay the the tax?

  • Some people reinvest capital gains but not dividends, and hope that the dividend distribution will be enough to pay the taxes on both.
  • Some people sell enough of their mutual fund shares to pay the tax.
  • Some people pay the tax from income, savings, or some other source that has nothing to do with the fund itself.

Another strategy all together is to factor in the tax history of a fund when selecting a fund to buy. "Actively managed" funds tend to have more turnover [not to say 'churn'] in their portfolio. That turnover tends to generate more capital gains income, as well as more 'management' expense.
Index funds tend to have less turnover, and therefore less capital gains income to distribute.