NEW YORK (CNN/Money) - Why do we pay so much in taxes on mutual funds?

The first reason, of course, has nothing to do with mutual funds. And that reason is that in its infinite wisdom our government sees fit to saddle us with what I consider onerous tax rates. But that's not a matter for me to address in my capacity as resident Expert, although I will say that if you want to lobby the boys and girls inside the Beltway for lower tax rates, you've got my wholehearted support.

As for the specific taxation of mutual funds, however, that's an issue I can address -- and even offer a few suggestions on how to minimize your tax bite.

Basically, there are three ways fund owners can end up owing taxes. (I'm assuming we're dealing here with funds that are held in taxable accounts, as opposed to IRAs, 401(k)s or other tax-advantaged accounts.) The first is if you sell fund shares at a profit. If you had owned those shares for a year or less, then your gain would be taxed at ordinary income tax rates, which can run as high as 39.1 percent this year and as high as 38.6 percent in 2002. If, on the other hand, you had owned the shares longer than a year, then you would be taxed at the more merciful long-term capital gains tax rate, which maxes out at 20 percent.

The second way you can owe taxes is if the fund pays dividends or interest. Let's say you own a bond fund. The bonds the fund owns make interest payments, which the manager is required by law to pass along to shareholders. The same goes with stock funds that own shares of companies that pay dividends. The manager must pass along those dividends as well. You may elect to take these interest payments or dividends in cash or have them reinvested in the fund, giving you additional shares. But either way, the IRS considers that interest and those dividends income, which means you've got to pay tax on them at ordinary income tax rates.

The third way you can owe taxes is because of the fund manager's trading. Let's say that throughout the year, the manager of a stock fund you own sold some shares the fund had held in its portfolio longer than a year for a profit of $2 million and other shares it had held longer than a year for a loss of $1 million. The fund would have a net long-term capital gain of $1 million, which, by law, must be distributed to shareholders. If the fund had one million shares, each shareholder would receive a $1 capital gain distribution for each share he or she owned. In reality, many funds make both long- and short-term capital gains distributions, usually once in at mid-year and then toward the end of the year. Again, whether you elect to receive those distributions or cash or in additional shares of the fund, you owe tax on those distributions. The long-term gains are taxed at a maximum of 20 percent, while the short-term gains are taxed at ordinary income tax rates.

Funny things is, though -- well, maybe funny isn't the right word -- shareholders can receive gains and owe taxes even if their fund has suffered a loss for the year. How, you may ask, is it possible to lose money in a fund yet still owe taxes? Simple. Let's say, the fund manager sells some shares that generate a profit of $1 per share. At the same time, though, let's assume that the fund suffered an even larger "unrealized" loss -- that is, the shares the manager didn't sell went down in value by more than $1 per share. In that case, the fund would report a loss, but shareholders would still owe tax on the "realized" gain that was distributed to them, even if in not in cash but in re-invested shares.

So what can you do to minimize the taxes you owe on your fund holdings? Well, by holding shares rather than selling them, you certainly have the power to postpone taxes due to your own trading. And if you do have to sell, then you may at least have the option of mitigating the tax bite by selling the shares in which you have the smallest gain or shares that you've held longer than a year. For that matter, you might be able to erase gains in some sales by booking losses in others. (For more on how to do that, click here.)

As for taxes due to interest and dividends, well, that's tougher. If you own bond funds, I think you pretty much just have to accept that you're going to owe taxes on distributions. One thing you might consider is holding any bond funds you own within a tax-advantaged account -- an IRA, 401(k), etc. -- rather than a taxable account.

When it comes to the taxes caused by the fund manager's trading, however, you do have a way to minimize, if not eliminate, them. And the way to do that is by investing in "tax-efficient" funds -- that is, funds that tend to generate fewer taxable distributions. Most index funds, for example, are inherently tax-efficient because index fund managers for the most part buy and hold the securities of whatever index the fund follows rather than trying to trade for profits. Another breed of funds known as "tax-managed" funds employ specific strategies to hold the tax burden down. For example, if the manager has sold some stocks at a profit, he might look for other securities he can sell at a loss to offset that gain. By using this and other techniques, tax-managed funds can do a good job of keeping taxable gains to a minimum. (For more on tax-efficent and tax-managed funds, click here.)

Bottom line: you probably can't completely escape taxes on fund gains, at least not legally. But if you try a few of the moves I've suggested above, you should at least be able to lower your tax burden.