(MONEY Magazine) – Mutual funds are supposed to be a bit dull; when they get interesting, watch out. On Nov. 11 of last year, a 67-year-old physician in San Francisco invested $50,000 in a mutual fund called BT Investment Pacific Basin Equity. (Since he has asked me to keep his name confidential, let's call him Dr. X.) Then, early this January--scarcely seven weeks after he had bought the BT fund--Dr. X opened an innocent-looking envelope and got the shock of his investing life. On his original $50,000 investment ($50,363.48, to be exact), BT Pacific Basin had paid out $22,211.84 in taxable capital gains. This was not good: Every penny of the payout was a short-term gain, taxable at Dr. X's ordinary income tax rate of 39.6%. On a fund from which he had not sold a single share, he suddenly owed nearly $9,000 in federal taxes. As a California resident, he was also in the hole for $1,000 in state tax.

How is Dr. X feeling? "Ripped off," he says. "This is truly outrageous. I'd thought if a fund were properly managed this kind of thing wouldn't occur--or, at the very least, I should get enough forewarning to get out of the fund before it did occur." And what has he learned? "Oh, I should have been much less accepting of the idea that fund managers will do the right thing for their investors," he says with a bitter laugh. "Evidently they don't."

Al Coles, the financial planner who put Dr. X in the fund, believes BT should have notified potential investors of the pending tax liability. "Fund companies love sending investors all this marketing crap that doesn't mean anything," says Coles of Financial Design Associates in Stinson Beach, Calif. "So how come when there's a vital and valuable piece of information, they can't be bothered to send it out?"

Capital-gains taxes without the gains

Could you end up in the same mess as Dr. X? You bet. Stock and bond funds paid out $184 billion in taxable gains in 1997 and another $166 billion in 1998. Those payouts cost investors roughly $50 billion in federal taxes each of those years. And in the zany world of fund taxes, you don't owe Uncle Sam only when you sell at a profit. You can owe when your fund sells one of its holdings at a profit, even if you've never sold a share. As with a stock split, when a fund makes a distribution, the total value of your account does not change, but you end up owning more shares at a lower price. Unlike a stock split, however, a fund distribution is taxable immediately--regardless of whether you reinvest it in more fund shares or the fund company sends you a check.

A poorly managed fund can even stick its investors with a big capital-gains bill at a time when the fund is losing value. This happens if the fund sells its winners without offsetting those gains by selling some losers, and it happens far more often than investors realize. All told, investment analyst James Garland at the Jeffrey Co. in Columbus, Ohio estimates that federal taxes consumed a hair-raising 47% of the typical stock fund's performance from 1971 to 1995. On the other hand, several well-managed funds, including Vanguard Tax-Managed Capital Appreciation and Schwab 1000, have never paid out a taxable capital gain and have allowed their investors to retain at least 97% of their performance after taxes. In short, whether your fund manager beats the market is entirely out of your hands (and perhaps his too), but it's well within your power to choose funds that will not torture you at tax time.

To make the best choices, it helps to understand how mutual funds handle taxes. Let's say you're in the 31% federal tax bracket and you own two funds, both of which go up 10% for the year. One fund generates only unrealized paper profits, leaving you with $1,100 for each $1,000 you invested. At the other fund, however, winners are sold within 12 months and the gains are not offset by selling losers. As a result, all the profit is realized as short-term capital gains; this account too is worth $1,100--but you've got to pay Uncle Sam $31, or 3.1% of what you invested. That reduces your 10% pretax gain to just 6.9%. After tax, the first fund is a better deal.

"Perhaps we were too successful"

When Dr. X bought BT Pacific Basin, what he got instead of a mutual fund was a tax grenade whose pin had already been pulled. The fund had generated the bulk of its capital gains months earlier. By early November, the time to offset them with losses was running out fast. Only on Nov. 19 did BT finally estimate that it would distribute more than $2 a share in short-term gains--but, unlike many other fund companies, BT did not share that warning with discount brokers, transfer agents and other third parties. You had to call and ask.

I asked BT to explain. Warren Howe, co-manager of the Pacific Basin fund, says the taxable gains were generated by BT's successful trading of Asian currencies--which helped push the fund's performance far ahead of its peers in 1998. (The fund, which buys stocks in the Far East outside of Japan, finished 1998 with a return of -6.6%.) "We did make a lot of money on currencies," said Howe. "Perhaps in some sense we were too successful." Perhaps. But panicked by the plunge in emerging markets, investors pulled their money out of the fund throughout 1998. The currency gains were achieved early in the year, when the fund had about $30 million in assets; by December, when the assets had fallen to $4.2 million, far fewer shareholders remained, and they got stuck with all the taxable gains.

Wouldn't it have been a good idea, I asked Howe, for your prospectus to warn investors that aggressive currency trading can have unpleasant tax consequences? His answer came in a bland tone of detachment: "I haven't really got a strong view on whether it should be specifically disclosed. I'd think that would be something that the investor base should already be aware of."

And should BT have tried harder to spread word of the pending payout? Howe rightly pointed out that it's not portfolio managers, but other fund company executives, who make that kind of decision. But, he conceded, "I suppose that would have been fair under these circumstances."

And what words of encouragement would Howe offer Dr. X, after the doctor had been forced to pay a $10,000 tax bill on his $50,000 investment?

"Our currency management made a positive contribution to return," said Howe, "even after tax."

Fighting back

Howe's response is a reminder that many fund bigwigs share the haughty view of Leona Helmsley: "It's the little people who pay taxes." Luckily, we little people can protect ourselves from fund tax bombs. Here's how:

--Listen to history. Last year was the second in a row that BT Pacific Basin dumped a big tax bill on its shareholders. Funds with high taxable payouts in the past will tend to have them in the future.

--Watch the calendar. Around Thanksgiving, many funds give warning of their year-end taxable payouts. If you haven't invested earlier in the year, hold your fire until a tax estimate is available. If the pending payout turns out to be big, find a different fund.

--Read the fine print. Every fund's annual and semiannual reports (available from the company or online as "Form N-30D" at www.freeedgar.com) include a statement of assets and liabilities. Look for this lingo: net unrealized appreciation, undistributed net investment income and undistributed net realized gain. While they can change by the end of the year, these numbers are fair estimates of tax overhang; if together they exceed, say, 15% of total net assets, you're looking at a fund that could make you a tax victim. Last Nov. 23, after Dr. X had already invested, BT Pacific Basin filed its Sept. 30 annual report, showing that its undistributed net investment income exceeded 50% of total assets.

"If they've got a big number there," says Matt Forstenhausler, a partner in the asset management group of accounting firm Ernst & Young, "you should think, 'They could distribute that to me.' The intent of these numbers is to give people an idea of potential taxes, and I always check them before I buy a fund."

--Think twice before buying a shrinking fund. Once the BT fund shriveled in size, the year-end shareholders had to foot everyone else's tax bill.

--Buy index funds. Because these market-replicating funds rarely realize capital gains, they are highly tax-efficient. That's Reason No. 179 why long-term investors should have most of their money in index funds.

Jason Zweig can be reached at fundamentalist@moneymail.com