More mutual fund investors will be hit with higher tax bills again this year as the trend for increasing capital gains taxes continues unabated.

   The average U.S. equity fund will pay 6.89% of year-end net asset value for 2007, compared to 4.17% for 2006. It was only 1.67% in 2004. Likewise, the average pay-out for international funds grew to 7.49% versus 4.98% in 2006, and the pay-out for balanced funds jumped to 3% last year versus 1.95% the prior year. The main reason for the rising pay-outs and resulting yearly increases in capital gains tax liabilities is that funds had used bear market losses to offset gains, and those losses have dried up.

   A fund can stick investors with a tax bill even if the individual investor didn't make money because capital gains are based on gains that the fund realized and distributed to all shareholders equally regardless of the individual investor's cost basis, says Morningstar analyst Russel Kinnel. He adds that if the current economic downturn continues the trend will reverse and future capital gains will be offset by fund losses.

   Kinnel advises ways to limit capital gains tax liability include putting the maximum in tax sheltered accounts; using tax-managed funds for taxable accounts; investing in diversified, low-cost and low-turnover exchange traded funds; and avoiding funds that have had huge returns over the past three years.