Over the last few years there has been much talk about reductions in the tax on capital gains. These cuts have finally been enacted as part of the Taxpayer Relief Act of 1997. New, lower rates for long term capital gains apply to gains realized after May 6, '97. As discussed below, with certain minor exceptions, long term capital gain rates have been reduced from 28% to 20% and, for certain lower income taxpayers, from 15% to 10%. (These rates also apply for purposes of the alternative minimum tax.) However, the new law has also extended the holding period rules so that to qualify for these lower rates you must hold the asset for more than 18 months. A special rule applies to assets sold after May 6, 1997 and before July 29, 1997. If you sold any capital assets during this period, you qualify for the new lower rates as long as you held the asset for more than one year.

With respect to sales after July 28, 1997, there are three different kinds of capital gains with different treatment for each. As under prior law, net short term capital gains remain taxable at ordinary income tax rates (15% to 39.6%). Short term capital gains continues to mean gain from the sale or exchange of a capital asset held for one year or less. Mid-term capital gains (from the sale of assets held more than a year but not more than 18 months) are taxed at a maximum rate of 28%. And finally, long-term gains (which now means gain on the sale of assets held more than 18 months), which are taxed at a maximum rate of 20% (10% to the extent they would be subject to tax at a 15% rate if taxed as ordinary income).

Example. Tom, a single individual, has taxable income other than capital gains of $80,000 in 1997 (putting him in the 31% tax bracket). He also has $10,000 of long-term capital gains from sales after July 28, 1997, $5,000 of mid-term capital gains, and $2,000 of short-term capital gains. Although Tom is otherwise in the 31% tax bracket, only the $2,000 of short-term gain is taxed at that rate (for a tax of $620). The $5,000 of mid-term gain is taxed at 28% (for a tax of $1,400) and the $10,000 of long-term gain is taxed at 20% (for a tax of $2,000).

Mutual funds. If you are an investor in mutual funds, you can expect to receive an information return (Form 1099) next January with more information than in the past. The form will have to separately report the different kinds of gain so that they can be properly reflected on your return.

Family tax planning opportunity. Given the 10% rate for low bracket taxpayers, if you have appreciated stock or other capital assets that you are thinking of selling, you may wish to consider transferring the asset to children over 13. To the extent their other taxable income is below the 28% tax bracket amount ($24,650 this year), they can take advantage of the low (10%) rate for net capital gains. (For children 13 or under the "kiddie tax" rules can cause the child's income to be taxed at the parent's (higher) tax rates.)

Other rules and exceptions. For capital gains attributable to collectibles, the tax rate remains at the old maximum rate of 28%. And part of the capital gain from the sale of depreciable real property may be subject to a 25% maximum rate if certain recapture rules apply.

Although the tax rates have been changed for capital gains as outlined above, those gains continue to be included in adjusted gross income (AGI). Thus, they will still have an impact on any related tax area dependent on AGI. These include itemized deductions for medical expenses, casualty losses, and miscellaneous itemized deductions as well as the phase out of itemized deductions and personal exemptions, and the inclusion in gross income of Social Security benefits.

• Purchase of bond. If you buy a tax-exempt bond for its face amount, either on the initial offering or in the market, there are no immediate tax consequences. If you purchase such a bond between interest payment dates, you will have to pay the seller any interest accrued since the last interest payment date. This amount is treated as a capital investment and is deducted from the next interest payment as a return of capital.

If you buy a tax-exempt bond at a premium, you must amortize the premium over the term of the bond. While no deduction is permitted for the amount of premium amortized in each year, the effect of this is to reduce your basis in the bond by a corresponding amount. Thus, if you buy such a bond at a premium and hold it to maturity, you won't recognize a loss when the bond is paid off.

If you buy a tax-exempt bond at a discount, see below.

• Exclusion of interest from taxable income. In general, interest you receive on a tax-free municipal bond is not includible in gross income (although, as discussed below, it may be includible for alternative minimum tax purposes). While this is an attractive feature, keep in mind that a municipal bond is likely to pay a somewhat lower rate of interest than an otherwise equivalent taxable investment. What is really significant isn't whether the interest is included in income, but rather what the after-tax yield is.

In the case of a tax-free bond, the after-tax yield is generally equal to the pre-tax yield (although alternative minimum tax consequences may also have to be taken into account). In the case of a taxable bond, the after-tax yield will be based on the amount of interest you have left over after taking into account the increase in your tax liability on account of each year's interest payments. This will depend on your effective tax bracket. In general, tax-free bonds are likely to be more attractive for taxpayers in higher brackets, since they receive a greater benefit from excluding interest from income. For lower-bracket taxpayers, on the other hand, the tax benefit from excluding interest from income may not be enough to make up for the lower interest rate generally paid on this type of bond.

I can help you with the effective yield calculations necessary to make a meaningful comparison of different investments.

Even though municipal bond interest isn't taxable, it must be shown on the return. This is because tax-exempt interest is taken into account when determining the amount of social security benefits that is taxable, and may affect the alternative minimum tax computation as well as the earned income credit and investment interest deduction, see below.

• Tax-deferred retirement accounts. It generally doesn't make sense to purchase and hold municipal bonds in your IRA, Keogh, or 401(k) plan account. The income in these accounts is not taxed currently, but once you start making withdrawals, the entire amount withdrawn is likely to be taxed. Thus, if you want to invest your retirement funds in fixed income obligations, it is advisable to invest in higher-yielding taxable securities.

• Alternative minimum tax consequences. Even though interest on municipal bonds is generally excluded from income for purposes of the regular federal income tax, interest on certain "private activity bonds" is included in income for purposes of the alternative minimum tax. Your broker can tell you whether the particular bond you are considering is a private activity bond subject to this rule.

The alternative minimum tax is a separate tax system which applies if the tax determined under that system exceeds your regular income tax. Whether or not the alternative minimum tax applies will depend on your overall tax picture; however, in general, the effect of the alternative minimum tax would be to prevent you from achieving too low an effective tax rate by means of tax-favored techniques such as investing in municipal bonds. We can help you determine how the alternative minimum tax would apply to your situation, and how it would affect the after-tax yield if you were to invest in municipal bonds.

• Effect of exempt interest on taxation of Social Security benefits. In general, a portion of Social Security benefits is taxable if your adjusted gross income, subject to certain modifications, exceeds specified amounts. For this purpose, the modifications to adjusted gross income include adding in tax-exempt interest. The effect of this rule is that, if you receive Social Security benefits, investing in municipal bonds could increase the amount of tax you have to pay with respect to the Social Security. While technically the municipal bond interest remains exempt from taxation, the effect is the same as though a portion of that interest were taxable.

I can help you with the calculations necessary to determine whether and how you would be affected by these rules.

• Effect of exempt interest on earned income credit. If you are otherwise eligible to take an earned income credit, you will lose the credit completely if you have more than $2,250 (in 1997) of "disqualified income," generally, interest, dividend, nonbusiness rental, passive, and capital gain net income. Disqualified income includes tax-exempt income. And for tax years beginning after 1997, tax-exempt interest is included in AGI for purposes of applying the rules that phase out the credit as AGI increases over certain threshold amounts. Thus, municipal bond income could cause loss of the credit. However, in most cases, an individual who is eligible for the earned income credit will be in a low tax bracket, thus making municipal bonds an unattractive investment in view of their lower yield, as discussed above.

• No deduction for interest on obligations incurred in connection with tax-exempt investments. If you borrow money for the purpose of investing in municipal bonds, you can't deduct the interest expense with respect to that borrowing. Moreover, even if the proceeds of borrowing aren't directly traceable to tax-exempt investments, interest deductions could be disallowed if IRS could establish that you continued the borrowing in effect (that is, you didn't pay it off) for the purpose of acquiring or carrying the municipal bonds. If you have otherwise deductible interest and invest in municipal bonds, the effect of this rule, by denying a deduction for interest paid, could be effectively to tax the municipal bond interest.

• Sale, call or redemption of bond. Normally, the sale, call prior to maturity, or redemption of a municipal bond is treated in the same manner as a taxable bond. Depending on the length of time you held the bond, any gain or loss is taxed as a long-term or short-term capital gain or loss. Long-term gain is taxed at favorable rates. Capital losses can be used to offset other capital gains. Up to $3,000 of any remaining losses can generally be applied against other income, with a carryover of any excess to subsequent years.

• Market discount on disposition. Ordinarily, when you sell a bond which you have purchased in the market, any gain you realize is taxed as long-term or short-term capital gain (depending on how long you held the bond). However, where you purchase a bond with "market discount," gain not exceeding the portion of the discount that accrues during the period you hold the bond is treated, when you sell it, as ordinary income. This rule applies to tax-exempt municipal bonds bought after April 30, 1993. Since, depending on your tax bracket, ordinary income may be taxed at a higher rate, the effect of this is to reduce the benefit of tax-exempt bonds relative to taxable bonds, in the case of bonds trading at a discount.

• Municipal bond funds. If you are looking for diversity and professional management for your municipal bond holdings, you may want to consider buying shares of a mutual fund that invests in tax-exempt municipal bonds. A fund that's invested at least 50% in tax-exempt obligations may distribute exempt-interest dividends to its investors. These are treated in essentially the same manner as municipal bond interest. To preclude a potential tax loophole, if an investor buys mutual fund shares, receives an exempt-interest dividend, and then sells the shares at a loss within six months after the purchase, the loss is disallowed to the extent of the exempt-interest dividend.

Split-dollar life insurance isn't a type of policy. Rather, it's an arrangement under which rights and obligations relating to a cash value policy on your life are split between you and your employer. Depending upon the type of arrangement, the employer pays part or all of the premium and retains an interest in the policy's cash value and death benefits sufficient to recoup its advances at a later date. If your employer doesn't pay the entire premium, you would have to pay the balance.

There are different ways to set up a split-dollar arrangement. Your employer could own the policy, or you or a trust could own it and assign an interest in the policy to your employer as collateral for the obligation to repay the premium payments the employer will make. You might want the policy to be owned by a trust, so that its proceeds wouldn't be taxed in your estate. The exact form that you use will depend upon what you and your employer want from the arrangement.

As far as your taxes go, you will be taxed each year on the value of the death benefit protection you receive under the split-dollar arrangement, less the amount you contribute to the premium. That value can be based on IRS tables or the actual one-year term premium that your insurer would charge to standard risks for the amount of death benefit you receive under the arrangement. Using actual term rates almost always produces a better tax result, but the rates used have to meet some strict standards laid down by IRS. Many insurance companies have one-year term plans that satisfy IRS's requirements; their agents will be happy to give you information.

If your split-dollar arrangement will entitle you to the policy's cash value in excess of the amount of premiums paid by the employer, you will also be taxed on that value. If the employer owns the policy, that value may not be taxed to you until some point when the policy is transferred to you. If you or a trust owns the policy, IRS says that the increases in cash value that you are entitled to under the arrangement are taxed to you each year as they accrue in the policy.

The most important thing to remember is that split-dollar is a very flexible benefit, that can serve many purposes

As a parent with college-bound children, you are or will soon be concerned with either setting up a financial plan to fund for future college costs, or, if your children are already college age, with paying for current or imminent tuition, etc. bills. I'd like to address both of these concerns by suggesting several approaches that seek to take maximum advantage of tax benefits to minimize your expenses. (Please note that the following suggestions are strictly related to tax benefits. You may have non-tax-related concerns that make the suggestions inappropriate.)

Planning for college expenses. In many cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $20,000 Amount to be increased for inflation after '98.</fntxt> a year in cash or assets to each child with no gift tax consequences. For children over 13, the income from the assets is taxed entirely to them at their lower tax rates (15% in most cases). For children under 14, however, income above $1,400 (in 1998) is taxed (under the "kiddie tax" rules) at your rates.

Amount to be increased for inflation after '98.

A variety of trusts or custodial arrangements can be used to place assets in your children's names. Note, it's not enough just to transfer the income to them, e.g., dividend checks. The income would still be taxed to you. You must transfer the asset that's generating the income into their names.

Tax-exempt bonds. Another way to achieve economic growth while avoiding tax is simply to invest in tax-exempt bonds or bond funds. Interest rates and degree of risk vary on these so care must be taken in selecting your particular investment. Some tax-exempts are sold at a deep discount from face and don't carry interest coupons. Many are marketed as college savings bonds. A small investment in these so-called zero coupon bonds can grow into a fairly sizable fund by the time your child reaches college age. "Stripped" munis carry similar advantages.

Series EE U.S. savings bonds. Series EE U.S. savings bonds offer two tax-savings opportunities when used to finance your child's college expenses: first, you don't have to report the interest on the bonds for federal tax purposes until the bonds are actually cashed in; and second, interest on "qualified" Series EE bonds may be exempt from federal tax if the bond proceeds are used for qualified college expenses.

To qualify for the tax exemption for college use, the bonds must be purchased by you in your name (not the child's) or jointly with your spouse. The proceeds must be used for tuition, fees, etc. (not room and board). If only part of the proceeds are used for qualified expenses, then only that part of the interest is exempt. But there's a danger: if your adjusted gross income (AGI) is too high, the exemption is phased out. Based on the 1998 rates, the exemption starts to "disappear" when your (joint) AGI hits $78,350 (for taxpayers filing joint returns) and is gone entirely if your AGI is at $108,350 or higher. (These figures are adjusted annually for inflation.) So for many taxpayers the savings bond exemption offers no tax savings.

Michigan-type educational trusts. Tax-favored treatment applies to qualified state tuition programs that allow parents to save for their children's college costs on a pre-paid basis. A number of states (starting with Michigan) have adopted what amount to "pre-payment" programs for college expenses. Under these programs, parents pay amounts into state-organized trusts well in advance of the time their children are due to enter college. The amounts vary depending on the age of the child—the younger the child, the smaller the payment. The trust then keeps and invests the money, and contracts with the parents to pay for the child's education at a state school (or, sometimes, at a private school within the state). The contributions are treated as taxable gifts to the child but they are eligible for the annual $10,000 Amount to be increased for inflation after '98.</fntxt> gift tax exclusion, and a donor who contributes more than the annual exclusion limit for the year can elect to treat the gifts as if they were spread out over a 5-year period. The earnings on the contributions accumulate tax-free until the college costs are paid from the funds. At that time the amounts are taxed to the child to the extent they exceed the amount contributed by the parents. Refunds are available under certain circumstances—for example, if the child dies before entering college, becomes disabled, or receives a scholarship. Refunds for any other reason must be subject to a penalty in order for the program to qualify for tax-favored treatment.

Amount to be increased for inflation after '98.

Education IRAs. Beginning in 1998, you can establish education IRAs and make contributions of up to $500 a year for each child under age 18 if your (joint) AGI is under $160,000. Although the contributions aren't deductible, funds in the account aren't taxed, and distributions are tax-free if spent on higher education expenses. If the child doesn't attend college, the money must be withdrawn when the child turns 30, and any earnings will be subject to tax and penalty, but unused funds can be transferred tax-free to an education IRA of another child in your family.

The above are just some of the tax-favored ways to build up a college fund for your children. If you wish to discuss any of them, or other alternatives, please call.

Paying college expenses. Beginning in 1998, you may be able to take a credit for some of your child's tuition expenses or write off some of the interest on education loans. There are also tax-advantaged ways of getting your child's college expenses paid by others.

Tuition tax credits. Beginning in January, 1998, you can take a tax credit of up to $1,500 a year per student for the first two years of college (a 100% credit for the first $1,000 in tuition and a 50% credit for the second $1,000). Beginning in July, 1998, you can take a credit of up to $1,000 per family for every additional year of college or graduate school (a 20% credit for up to $5,000 in tuition). The credit for the first two years of college is called the HOPE credit, and the credit for later years is called the Lifetime Learning credit. Both credits are phased out for couples with incomes between $80,000 and $100,000.

Deduction for education loan interest. Starting in 1998, you can deduct interest on student loans. The maximum deduction is $1,000 for 1998, $1,500 for 1999, $2,000 for 2000, and $2,500 for 2001 and after. The deduction, which is an above-the-line deduction (meaning that it is available even to taxpayers who don't itemize), is allowed only for interest paid during the first 60 months in which interest payments on an education loan are required. The deduction isn't available for couples whose AGI is over $75,000.

Scholarships. Scholarships (if your child qualifies for any) are exempt from income tax. For this exemption to apply, certain conditions must be satisfied. The most important are that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies and similar items (and not for room and board).

Employer educational assistance programs. If your employer pays your child's college expenses, the payment is a fringe benefit to you, and is taxable to you as compensation, unless the payment is part of a scholarship program that's "outside of the pattern of employment." Then the payment will be treated as a scholarship (if the other requirements for scholarships are satisfied).

Tuition reduction plans for employees of educational institutions. Tax exempt educational institutions sometimes provide tuition reduction plans for the children of their employees—tuition reductions for those children who attend that educational institution, or cash tuition payments for children who attend other educational institutions. If certain requirements are satisfied, the tuition reductions are exempt from income tax.

College expense payments by grandparents and others. If someone other than you pays your child's college expenses, the person making the payments is generally subject to the gift tax, to the extent the payments and other gifts to the child by that person exceed the regular annual (per donee) gift tax exclusion of $10,000 ($20,000 Amounts to be increased for inflation after '98.</fntxt> in the case of married donors who consent to split gifts). If the other person pays your child's school tuition directly to an educational institution, however, there's an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant, but the payer would typically be a grandparent. The exclusion applies only to direct tuition costs. There's no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc..

Amounts to be increased for inflation after '98.

Bank loans. You may of course take out loans to pay for your child's educational expenses. The interest on such loans is personal interest, which is not deductible unless you qualify for the deduction for education loan interest, described above. However, if the loan is "home equity indebtedness," and interest on the loan is "qualified residence interest," the interest is deductible for regular income tax purposes, although not for alternative minimum tax purposes. If interest is deductible as qualified residence interest, it can't be deducted as education loan interest.

Borrowing against retirement plan accounts. Many company retirement plans permit participants to borrow cash. This option may be an attractive alternative to a bank loan, especially if your other debt burden is high. However, the loan must carry an interest rate equal to the prevailing commercial rate for similar loans, and, unless you qualify for the deduction for education loan interest (described above), there's no deduction for the personal interest paid. Moreover, unless strict requirements are satisfied, a loan against a retirement account is treated as a premature distribution (withdrawal) that's subject to regular income tax and an additional penalty tax.

Withdrawals from retirement plan accounts. Qualified retirement plans and IRAs represent the largest cash resource of many taxpayers. IRA funds can be tapped at any time and, beginning in 1998, you can pull money out of your IRA to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals from an IRA before age 59 ½ . But some qualified plans either don't permit withdrawals or restrict them. For example a 401(k) cash-or-deferred plan may allow distributions if the participant has an immediate and heavy financial need and lacks other resources to meet that need. IRS regs name a college education as such a need.

To the extent they represent previously untaxed dollars and earnings, amounts withdrawn from a retirement plan are fully subject to tax and are also hit by a 10% penalty tax if they are made before the participant reaches age 59 ½ , except that IRA funds can be withdrawn to pay for college costs without incurring the penalty, as discussed above.

A younger plan participant may avoid triggering the penalty tax by annuitizing payouts from an IRA or a SEP. This method doesn't work for 401(k) type plans. The strategy works because the penalty tax doesn't apply if annual or more frequent withdrawals are made in substantially equal payments over the life or life expectancy of the taxpayer (or the joint lives or joint life expectancies of the taxpayer and designated beneficiary).

The tax rules for the program were enacted as part of the Small Business Job Protection Act of 1996 and were recently amended as part of the Taxpayer Relief Act of 1997.

The law allows states to set up tuition programs. Under the plan, you transfer funds to the tuition program designed for this purpose, and the funds will be held in a special account to be used to cover future higher education costs for the individual you designate as the beneficiary. Qualified costs are those for tuition, fees, books, supplies, equipment, and room and board. Expenses for graduate level courses qualify.

The funds are invested while held by the program, although you will not have the right to direct the investment. The earnings are not taxed while the funds are in the program. This is the central tax benefit of the plan: it permits tax-free growth on the funds set aside for future education expenses.

When the funds are used for the beneficiary's higher education, only the earnings will be taxed to the beneficiary, not the contributions. Note, as well, that the earnings are taxed to the child (at his or her low tax rates), and not to you. Of course, you can make a separate transfer to the child to cover this tax liability.

If the funds in the program are refunded to you and not used for the beneficiary's higher education, a penalty will be imposed on the refund (unless the refund is made on account of a scholarship received by the beneficiary which reduces the tuition needs). Additionally, in the event of a refund, of course, the earnings in excess of your contributions will taxed to you instead of the beneficiary.

A contribution to a qualified tuition program is subject to the gift tax, but contributions are eligible for the $10,000 annual gift tax exclusion. A distribution from a qualified tuition program isn't a taxable gift. A change in the beneficiary under the program, or a rollover to the account of a new beneficiary, is a taxable gift and a generation-skipping transfer from the old beneficiary to the new beneficiary only if the new beneficiary is assigned to a generation below the old beneficiary

No interest in a qualified tuition program is included in the estate of any person for estate tax purposes, except for an amount distributed on account of the death of a beneficiary. Thus, the value of an interest in a qualified tuition program is included in the estate of the designated beneficiary, not in the estate of the contributor.

Many of our clients are investors in mutual funds while others have expressed an interest in putting some of their investment money into mutuals. A complex set of tax rules need to be considered when making decisions about when to invest, what type of fund to invest in, dividend options, switching between funds within a mutual fund family, and selling shares.

What type of fund. There are literally thousands of mutual funds that you can choose from to invest in. The choice of fund generally narrows based on one's investment preferences and goals, e.g., high current yield income, long-term appreciation, or tax-free income. These considerations are generally the same as would be applied in making a direct investment in corporate stock, bonds, etc.

As among the choice of funds, if you have unused capital losses carried over from an earlier year, you might prefer to invest in a fund whose objective is capital appreciation rather than current income. Capital gain distributions by the fund can be offset by the loss carryover so that in effect the distribution is tax-free. If your income puts you in a high tax bracket, you might want to select either a fund seeking capital appreciation (to take advantage of the favorable rates on long-term capital gains) or a tax-free bond fund.

However, it's important to remember that regardless of the type of fund selected, distributions from any fund, even a so-called tax-free bond fund (see below), can have unanticipated tax consequences to the investor.

When to invest. A purchaser of mutual fund shares owns a proportionate share of all of the fund's investment holdings, including, in addition to the stock and bonds that comprise the fund's portfolio, any accrued but undistributed interest or dividend income and capital gains earned by the fund. If you buy mutual fund shares shortly before a dividend distribution, you may be buying a tax liability. The share price you pay reflects this income right. Say for example that you buy 1,000 mutual fund shares for $10 a share shortly before the fund declares and pays a dividend of $2 per share. As a result of the dividend, the per share price will drop to $8. More important, you will have to include the $2,000 ($2 x 1,000) dividend in your income (regardless of whether you receive the dividend in cash or reinvest it in additional fund shares) even though there has been no increase in the overall value of your investment. If the investment had been delayed until after the dividend. the same $10,000 investment would have purchased 1,250 shares (at $8 per share) and this problem of phantom income would have been avoided.

Nature of fund distributions. A mutual fund or regulated investment company (the more formal name for these investment vehicles) is generally taxed as a conduit. They distribute all or most of their income to shareholders. These distributions can take the form of ordinary dividends, capital gain distributions, tax-exempt-interest dividends, and distributions that represent return of capital. A mutual fund shareholder will receive a Form 1099-DIV from the fund showing the total amount distributed and providing the information necessary to properly report those distributions on the shareholder's income tax return. It's worth noting that a fund that invests solely in tax-exempt municipal bonds may nonetheless generate taxable income. If the fund has realized a profit on the sale or disposition of such bonds, the resulting capital gain will be distributed and taxed to the shareholders.

The fact that the investor may choose to receive his distribution in additional shares in the fund (rather than in cash) does not affect the immediate tax consequences. A dividend reinvestment option is treated as if the investor had received the distribution in cash and then used the cash to acquire additional shares. These new shares have a basis equal to their cost, i.e., the amount of the dividend that was used to purchase them.

An investor who makes specific direct investments in stocks or bonds can generally control when and to what extent to realize capital gains. This is not true to the same extent with mutual fund investments. If a fund's investment portfolio has done well in a given year, the fund may make a large distribution near the end of the year because of gains that it has realized. These will be taxed to the investor as ordinary dividend to the extent of short-term gains, and capital gain distribution to the extent it represents long-term gains of the fund. Because the fund may wait until late in Dec. before announcing the amount that it is distributing, year-end tax planning can be more difficult for individuals with substantial mutual fund holdings.

So-called "index funds" offer a way to avoid most of the problems associated with capital gain distributions. Index funds generally invest in the stocks or bonds that make up some market index, e.g., the Standard and Poor's 500. They remain fully invested in the component elements of the underlying index so that the price of the fund tracks the movement of the index. These funds generally do not sell any of their holdings unless necessary to provide funds for shareholder redemptions or to adjust for changes in the components of the index. As a result, these funds generally do not realize significant capital gains and their capital gain distributions are correspondingly low. Instead, appreciation in value is reflected in the price of the fund's shares and is only translated into capital gain when the investor chooses to sell.

In order to properly determine basis, see below, proper recordkeeping with respect to reinvestment of fund distributions is very important.

Sale of fund shares. When an investor in a mutual fund sells some or all of his shares, gain or loss is recognized. The gain or loss is measured by the difference between the amount realized from the sale of the fund shares and the basis for those shares. One difficulty with mutual fund investments is that certain transactions are treated as sales even though they might not normally be thought of as such. Another problem can arise in determining your basis for shares sold, particularly if you are selling only a portion of your fund holdings and the shares were acquired at different times and at different prices.

What is a sale. No one is likely to dispute the fact that a sale occurs when an investor has all of his shares in a mutual fund redeemed and receives a check for the proceeds. Similarly, there is a sale if the investor directs the fund to redeem the number of shares necessary for a specific dollar payout, e.g., sufficient shares to produce a payout of $5,000.

A less obvious sale occurs if you are merely swapping funds within a fund family, for example the surrender of shares of the X Income Fund for an equal value of shares of the X Growth Fund received in exchange. Even though no money passes hands, this is treated as a sale of the X Income Fund shares.

Many mutual funds provide check writing privileges to their investors. This is often a convenient and speedy way to pay large bills (as compared to directing the fund to redeem shares and send you a check, which then must be deposited in your regular checking account and clear before you can draw against it). However, each time you write a check on your fund account you are making a sale of shares in the fund. Do this 20 or 30 times a year and you are going to have a fairly complex capital gains schedule attached to your income tax return.

Determining basis of shares sold. If an investor disposes of all of his shares in a particular mutual fund in a single transaction, determining basis is relatively easy. Simply add the basis of all the shares, i.e., the amount of actual cash investments (including any commissions or sales charges) plus distributions by the fund which were reinvested to acquire additional shares less any distributions that represented a return of capital.

The calculation becomes more complex if the investor is disposing of only a portion of his interest in the fund and the shares were acquired at different times and at different prices. Taxpayers can use one of several methods to identify the shares sold and determine their basis.

. . . First-in first-out method. The basis of the earliest acquired shares is used as the basis for the shares sold. If the share price has been increasing over the period of ownership, the older shares are likely to have a lower basis and thus result in more gain.

. . . Specific identification method. You can specify to the fund at the time of the sale the particular shares to be disposed of, e.g., "sell 200 of the 300 shares I purchased on July 1, 19XX". You must receive written confirmation of your specification from the fund. This method often can be used to lower the resulting tax liability by directing the sale of the shares with the highest basis.

. . . Average basis. IRS permits you to use the average basis for shares that were acquired at various times and that were left on deposit with the fund or a custodian agent. Under the single category method, you find the average cost of all of your shares regardless of how long you owned them. In applying the long-term and short-term rules, shares are considered to be sold in the order in which they were acquired. This method gives the investor less flexibility in choosing which shares to dispose of, but is relatively simple to apply.

An investor can also use a somewhat more complex double category method which determines the average basis for two separate groups of shares, those held long-term and short-term holdings. As with the specific identification method, above, the investor specifies from which category the shares are to be sold.

As should be apparent, mutual fund investments raise a multitude of potential tax problems.

We wish to alert you to some tax surprises that your mutual fund investments may cause.

First of all, you may not be aware of at least a couple of unexpected ways in which you may make taxable "sales" of part of your interest in a mutual fund. You may already have made taxable "sales" of part of your mutual fund investment without knowing it.

One way this could happen is if your mutual fund allows you to write checks against your investment in the fund. IRS says that every time you write a check against your mutual fund account, you have made a partial sale of your interest in the fund. Except for money market funds where the share value is constant, you may therefore have taxable gain (or a deductible loss) whenever you write a check.

Here's another way you can get hit unexpectedly with taxable sale treatment. Say that your mutual fund organization allows you to make changes in the way your money is invested—for instance, lets you switch part of your investment from a stock fund to a bond fund. Making such a switch is treated as a taxable sale of your shares in the stock fund.

Recordkeeping is important. Be very careful about saving all the statements that the fund sends you—not only official tax statements, such as Forms 1099-DIV (or the fund's version of the 1099-DIV), but the confirmations that the fund sends you when you buy or sell shares, or when your dividends are reinvested in new shares in the fund. Unless you keep these records, you won't be able to prove how much you paid for the shares, and thus the amount of gain you have to pay taxes on (or the amount of the loss you can deduct) when you sell them. You will also need to keep these records to prove how long you've held your shares, e.g., more than 18 months if you want to take advantage of the 20% rate ceiling on such gains. (If you get a year-end statement that lists all your transactions for the year, then you can just keep that and discard quarterly or other interim statements or confirmations. But save anything that specifically says it contains tax information.)

Time your purchases and sales. If you're planning to invest in a mutual fund, there are some important tax consequences that you should take into account in timing the investment. For instance, an investment shortly before the payment of a dividend is something you should generally try to avoid, since you may, in effect, be buying a tax liability. If you're planning to sell (redeem) any of your mutual fund shares, timing is also important. A properly timed sale can save you tax dollars.

Identify the shares you sell. If you're planning to sell some but not all of your shares, there are complicated rules you should first consider about how to identify the shares you're going to sell. The proper application of these rules can reduce the amount of gain you will have to pay taxes on, or qualify the gain for favorable long-term capital gain treatment.

One of the principal reasons for buying U.S. savings bonds is the fact that interest can build up without the need to currently report or pay tax on it. The accrued interest is added to the redemption value of the bond and is paid when the bond is eventually cashed in. Unfortunately, the law does not allow for this tax-free build up to continue indefinitely. Series E bonds issued in 1956 reach final maturity after 40 years. Series E bonds issued in 1966 reach final maturity 30 years after issuance. Thus, bonds issued in those years reach final maturity this year. That means that not only will they stop earning interest, but all of the accrued and as yet untaxed interest is potentially taxable in 1996. A $1,000 E bond purchased in 1956 for $750 is now worth about $7,600. The entire difference (i.e., $6,850) is potentially taxable this year.

But there is a way to avoid having to pay tax now on all of the accumulated interest. This involves a special rule that permits further deferral if the E bond is exchanged for a Series HH bond. However, this exchange must be made within a prescribed time period.