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Remember that your tax liability is still the same even if you have chosen for your proceeds to be automatically re-invested back into the fund. When you sell your 200 shares, you would also have an additional capital gains income of

$10 (NAV appreciation from $50 to $60) x 200 shares = $2,000

This brings your total capital gains to

$3,800 + $2,000 = $5,800

So you would have to pay an income tax on $200 (in addition to your other regular income) and a capital gains tax on $5,800.

We already discussed where these distributions come from but let's look at them again. The income dividend distributions come from cash dividends on stocks and interest earned on bonds in the fund's portfolio, while the capital gains distributions come from the stocks that have been sold. It is also possible that the fund have not had a good year and sold some stocks at a loss. In that case you would have capital losses, which you would deal with accordingly in your tax return. Dealing with these taxable items is not as difficult as you may imagine, however. Most funds will send you a consolidated statement shortly after the end of the year indicating your distributions for that tax year. Therefore in most cases all you would have to do is to plug in the various figures in their appropriate locations in your tax forms.

Unfortunately, while you have the choice of not selling your fund shares and therefore avoiding the capital gains taxes on your sales proceeds, you have no control over the fund's capital gains distribution. This is really controlled by the fund itself as its portfolio is adjusted throughout the year by buying and selling various securities. And that …