There are a couple of reasons why mutual funds pay taxes. If the fund does poorly investors will bail out. The mutual fund has to sell off stock to pay the investors who leave. Even if you are not one of the investors jumping ship you will still have to pay your portion of the capital gains tax.

Dividends are another reason that taxes come due. Dividends are taxed at the per-share earnings distributions that companies make out of their quarterly earnings. Many investors instruct their mutual fund to automatically reinvest their dividends. This means that the fund uses the money to buy more shares in your name. Even if you reinvest and never get a penny of the dividends, they are subject to tax, according to the IRS.

Another reason you may get a tax bill is due to high turnover. Turnover measures the frequency with which a fund manger buys and sells shares, sometimes in search of the next high-flying stock or undervalued stock on the verge of taking off. According to Lipper, the average fund in 2000 showed a turnover rate of 122%. This means that the entire portfolio changed between January and December, and 22% of the replacement shares changed as well.

This is the ultimate case of account churning! You simply have to understand that when you buy into a fund you are buying into a tax liability. The best way to avoid these taxes altogether is to restrict your purchases of mutual funds to your 401(k) and try to only buy indexed mutual funds such as the Vanguard 500 (FINX).