Nov. 11 (Bloomberg) -- Mutual-fund investors reeling from losses in the stock market may face another hit next month: capital gains tax liabilities on their sinking funds.

Record mutual-fund withdrawals have forced managers to sell their profitable stocks to meet redemption requests, triggering distributions. The tax bill will arrive even if the fund had terrible annual returns.

``In this uncertain environment, investors should know that taxes are going up,'' Duncan Richardson, the chief investment officer of equities at Eaton Vance Corp. in Boston, said in an interview. ``Taxes are going to rear their ugly head in mutual funds this year.''

Investors removed $70.7 billion from stock funds in October after pulling $56 billion during the prior month, according to data from TrimTabs Investment Research in Sausalito, California.

Exchange-traded funds offer advantages that may help investors minimize the capital gains tax bite, financial advisers say. An investor can sell mutual-fund shares before the capital-gains distribution and buy an equivalent ETF. Holding an ETF for at least 30 days avoids the so-called wash rule, an Internal Revenue Service requirement to prevent reaping tax benefits from a short-term sale. After 31 days, the investor can repurchase the mutual fund or keep holding the ETF.

``The current market made what had been a marginal benefit into a major benefit,'' said Scott Burns, director of ETF analysis at Morningstar Inc. in Chicago.

Tax Advantage

The tax advantage helps explain the continued growth of ETFs. Even in October, when stock markets were dropping, ETFs saw a net $2.6 billion increase in assets, Burns said.

Eaton Vance, the largest manager of funds designed to lower taxes, completed a survey last month that shows that only 29 percent of investors believe they will pay taxes on capital gains in 2008, compared with 40 percent who actually paid them in 2007.

The Standard & Poor's 500 Index rose 5.5 percent in 2007, including reinvested dividends. Capital gains surged by a record 62 percent over the same period, according to the Investment Company Institute in Washington.

Taxes on fund distributions reached an all-time high of $31.3 billion in 2000, according to data from Lipper Inc., when the collapse of technology stocks sent the S&P 500 down by 10 percent.

Likely Gains

The Ivy Global Natural Resources Fund is likely to pay investors a $1.14 per share short-term capital gain, and a $2.52 per share long-term gain on Dec. 11. Investors will be paying taxes on those gains although the fund has declined 60 percent since the beginning of the year. The average U.S. diversified mutual fund declined 40 percent for the year through Oct. 31, according to Morningstar.

Fund holders generally are credited at the end of the year for mutual fund managers' stock sales. They pay for the entire year of gains from individual securities sales even if they bought the fund just before the distribution date.

Investors avoid the taxes if they sell, even if they held the fund all year and get out just before the distribution.

``It makes sense to sell assets at a loss if the fund will distribute taxable gains,'' said Steven Bove, president of Lebrigh Life Planners in Oldsmar, Florida. ``There is nothing less palatable than paying gains on a loser.''

Short-term capital gains are taxed as ordinary income. Long-term gains have a 15 percent tax rate, but that's scheduled to go up to 20 percent after 2010. That's where the rate was during President Bill Clinton's second term.

Write-Off Losses

Losses up to $3,000 can be written off on an investor's tax return. Losses beyond that can be carried over for future years. Financial advisers sometimes refer to this as ``harvesting losses.''

Advisers used to be limited to a small selection of ETFs when following this strategy, said Cathy Pareto, a fee-only planner in Coral Gables, Florida. The limited selection meant advisers would swap back into a mutual fund after 31 days. Now, sometimes they just stay in the ETF, she said.

``ETFs now command a much larger permanent stake in our portfolios because there are so many good ones now available,'' Pareto said.

At the end of 2007, ETFs held $608.4 billion in assets, compared with $12 trillion for mutual funds, according to the Investment Company Institute.

Fewer Gains

ETFs, which generally track a particular index, have fewer transactions from the sales of individual stocks than actively managed mutual funds. That means fewer gains to tax. Though it is uncommon for ETFs to pay capital-gains distributions, six funds have done so this year, according to Burns at Morningstar. That includes a sizable $6-per-share distribution for the Proshares Ultra Basic Materials ETF. This generally only happens with leveraged funds, Burns said.

The structure of ETFs also helps. Mutual-fund investors buy or sell directly from the fund. ETF shares trade among investors on an exchange. That means ETFs aren't as likely to have to sell securities to redeem investors.

ETFs are mostly passively managed, mirroring indexes rather than buying or selling securities based on a manager's choices, said Ted Toal, a fee-only planner in Annapolis, Maryland.

``Some investors, and a lot of advisers, are tired of the false promises of active management,'' Toal said.

Costly Move

An investor considering whether to sell a fund to avoid capital gains needs to look at how long the investment has been held. If it's been a while, the long-term gains may be more than the short-term distribution, making a move more costly.

The end-of-year distributions are one of the basic flaws of mutual funds, said David Blain, a fee-only financial adviser in New Bern, North Carolina. The end-of-year fund distributions are a hassle because they complicate planning, Blain said. Another is the need to pay fund management fees on top of the fee he already charges his clients.

``I never liked mutual funds because of the tax thing,'' Blain said. ``I hate trying to tax-plan with mutual funds. You're always waiting around.''

In the past, Blain has set up his own custom-made collections of stocks for his investors. He still does that for some, but now low-cost ETFs make it much easier. He also uses ETFs to diversify into other kinds of assets, such as currencies, commodities and real estate.

The Vanguard Group's family of ETFs offer a good value, with extremely low fees, he said. He's used Rydex Investments for currency shares and Invesco Limited's Powershares for commodities.

To contact the reporter on this story: Jeff Plungis in Washington at jplungis@bloomberg.net; Sree Vidya Bhaktavatsalam in Boston at sbhaktavatsa@bloomberg.net.

Last Updated: November 11, 2008 18:17 EST