Mutual funds can cause tax headaches because investors have no control over when and how much their funds realize in gains. Fund managers buy and sell securities for fund investors, often without taking tax considerations into account.

As we touched on last session, mutual funds must pass along to their shareholders any realized capital gains that are not offset by realized losses by the end of their accounting year. Mutual fund managers "realize" a capital gain whenever they sell a security for more money than they paid for it. Conversely, they realize a loss when they sell a security for less than the purchase price. If gains outweigh losses, the managers must distribute the difference to fund shareholders.

Fund managers also distribute any income that their securities generate. Obviously, a fixed-income fund, which owns bonds, will be paying out lots of income, and a stock fund that owns stocks that pay out regular dividends will also pass along dividends. While the NAVs of fixed-income funds are adjusted daily for income distributions, the NAVs of stock funds typically drop on the specific day an income distribution is made. 

As you may recall, when paying out capital gains or income, funds multiply the number of shares you own by the per-share distribution amount. You'll receive a check in the mail for the total amount. Or, if you choose to reinvest all distributions, the fund will instead use the money to buy more shares of the fund. After the distribution is made, the fund's NAV will drop by the same amount as the distribution. Fund companies often make capital-gains distributions in December, but they can happen any time during the year.

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