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How To Deal With Mutual Funds And Taxes

- Alan Lavine and Gail Liberman



Thinking of dumping a mutual fund that is under investigation and buying a new one?

Wait, warns Selva Ozelli, funds tax expert with RIA, a New York provider of tax software and information.

Reason: Most mutual funds pay out annual capital gains and dividends this month. So you could pay taxes on your new fund's profits even though you personally haven't earned any.

"Before jumping into a new fund in taxable accounts, wait until the new year, so as not to get hit with taxes on gains you've never recognized," Ozelli says.

On the other hand, if you hang onto your mutual fund, you could have some good news next year, she says. That's because mutual funds still are carrying forward losses on funds that got hammered in the bear market that started in 2000. This could help lower your 2004 taxes.

It's easy to get confused about mutual fund taxes. That's because you pay two sets: Taxes generated by your mutual fund which buys and sells investments, and taxes generated when you sell or earn income from your own personal fund shares. There also are a slew of different tax rates, depending upon whether you are earning dividend income, interest income, long-term capital gains or short-term capital gains.

The bottom line: Tax rates this year have dropped in general. But if your income tax bracket is greater than 15 percent, you could wind up paying higher taxes on interest income than on stock or stock fund income. Interest income refers to distributions from investments such as bonds, bond funds, bank accounts and money market funds. So rather than putting new stock or stock fund investments in tax-deferred or tax-exempt accounts, experts say you might want to start sheltering your interest-bearing investments. But before making any dramatic changes--other than just investing new money, consult with a tax adviser."There are not just 401 (k)'s and IRAs (for sheltering interest income)," Ozelli stresses. "There are variable annuity contracts and life insurance contracts."

Rande Spiegelman, vice president for the Schwab Center for Investment Research, San Francisco, reminds you to also:

· Consider taking investment losses in taxable accounts by Dec. 31 to offset any capital gains. While mutual funds "carry forward losses" instead of offsetting them with capital gains, you might be able to offset some of your personal mutual fund capital gains against losses if you sold shares this year. ye Max out contributions to your qualified employer retirement plan and IRA. Don't forget to contribute the additional catch-up allowance if you're at least 50 years-old. The more of your money you can shelter from taxes, and the earlier you can do it, the better.

· If you're self-employed, open a business retirement account.

· If possible, open a Roth IRA. Contributions are not tax deductible, but you can withdraw the money tax-free if you follow the rules for the account.

· Have your tax adviser evaluate the impact, if any, that the alternative minimum tax will have on you. If none, consider making quarterly estimated tax payments to your state by Dec. 31 instead of waiting until the new year. You may even want to pay your estimated state income tax balance due for next April 15, so you can accelerate it all as an itemized deduction on thisyear's tax return.

· Consider donating appreciated securities you've held for more than one year to a qualified public charity. You'll receive a full fair-market-value deduction and pay no tax on capital gains.

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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).


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