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Now here is the pitfall. That $25 per share distribution will be reported as capital gains and you will get hit with a capital gains tax for the $2,500 which let's say at 20% would be a tax hit of $500. Ouch. You are being penalized for investing in a fund. But this is more a penalty for investor's ignorance. If you had waited one week longer until after the distribution was made, you would have bought 200 shares of that fund at $25 per share and no capital gains distributions to pay taxes on. How to avoid such a pitfall? Check for the fund's distribution schedule and avoid buying into a fund when the distribution date is just around the corner. Unless of course you believe that fund will perform so well during the remaining time to distribution that it would easily cover your capital gains tax and then some. My advice, don't buy into a fund with one month or less to go until the distribution date. Buy it right after the distribution and save yourself from that immediate tax hit.

I'd like to wrap up this section with a couple of important notes. First, in many cases the cost of buying into a fund can be used to offset capital gains (i.e., it can be considered as capital loss). The cost includes items such as sales loads, transaction fees, and commissions. Always check with your tax adviser just to be sure. Second, if you own mutual funds through a retirement account, most likely you will not have to deal with taxes until you start withdrawing from it after retirement, at which point it would be taxed as ordinary income.

Rating

By some accounts there are as many as 40,000 mutual funds worldwide. With so many funds to choose from, how would you be able to separate the good ones from the bad? Of course good and bad is relative. My idea of good might be an aggressive growth fund, while you may consider an ultra-low risk value fund as a good choice. It's difficult …