My post on Tuesday dealt with selling money-losing investments by the year's end for tax reasons. It's a good idea, but doing so presents investors with a new dilemma: what to do with the proceeds?

That's easy: reinvest them - as soon as possible.

The hard part is choosing the new investment, and if you don't watch out you can get stuck with an unwelcome - but avoidable -- tax bill when you buy mutual fund shares late in the year - around now.

I won't go into all the investment-picking issues. Let's just assume you have a long-term asset-allocation plan, that you rely on mutual funds, and that you have a good idea of the general categories of funds you want to own. Since taxes are my subject of the week, I'd like to urge a serious consideration of "tax efficiency."

Basically, this refers to how deeply taxes chew into your investment gains. As I mentioned the other day, it's generally best to forestall tax bills as long as possible, which means choosing funds with high tax-efficiency rankings.

What determines that? The chief factor is the size of taxable distributions a fund makes during the year. Federal law requires that funds pay out the net gains, or profits, made on stocks, bonds or other holdings the fund managers have sold. The payments are generally made in November or December, and are reported on the 1099 form you receive in January. Distributions are subject to short- or long-term capital gains tax unless the fund is held in a tax-favored account like a 401(k) or IRA.

The most aggravating thing is that you have to pay this tax even if you automatically reinvest the distributions in more fund shares, as most people do.

Imagine you owned 1,000 shares of Fund X, valued at $10 a share, and that you received $1 a share in distributions. That $1,000 payment could trigger a $150 tax bill at the 15 percent long-term capital gains rate.

So what? You made $1,000... Of course you'll have to pay taxes! Well, this is where the nasty part comes in. Before the distribution was made, that $1 per share was counted among the fund's assets, so it contributed $1 to the share price. When the distribution is paid, the $1 is removed from the funds holdings, causing the share price to drop by $1.

Bottom line: After the distribution you have 1,000 shares valued at $9 each, instead of $10, and you have $1,000 in cash - a total of $10,000, the same as you had before the distribution. Except that you also have that $150 tax bill. If the distribution is reinvested it would buy 111.11 more shares, giving you 1111.11 shares at $9 each - total value $10,000. So the distribution doesn't make you any richer - it makes you poorer because of the tax bill.

This gets us to a key rule of thumb: Don't invest in a mutual fund that's about to make a large distribution. Doing so saddles you with a tax bill that can be avoided by waiting until after the distribution is paid. Holding off for a few weeks shouldn't make much difference to a long-term investor.

By early November most fund-company websites list estimated distributions each fund will make. The industry-wide record was $413.6 billion paid out in 2007. In 2008, the figure fell to $133.3 billion because the stock-market collapse left funds with smaller net gains.

Actively managed funds tend to have larger distributions than index-style funds, because managed funds do more buying and selling that triggers net gains. Because indexers use a buy-and-hold strategy, gains do not turn into distributions but remain part of the share price, or net asset value. You pay tax on those gains only after you sell the shares, allowing you to forestall tax bills for decades.

Morningstar Inc., the market-data firm, carries a wealth of tax-efficiency data on funds. At the site, key a fund's ticker symbol into the Stock/Fund window, then click the Tax tab. The most tax efficient funds have low Tax Cost Ratios, and their Tax-Adjusted Return is close to their PreTax Return. The page explains these terms.

Jeff Brown is an experienced business journalist and personal finance columnist who has written for The Philadelphia Inquirer, The New York Times, and TheStreet.com. Read his bio to learn more about him.

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