Paying less tax on mutual fund profits.

You've done a good job picking the right funds. Now boost your after-tax earnings with some simple techniques.

IF YOU HAD THE CHOICE OF PAYING more taxes on an investment--or less--which would you choose? Well, with mutual funds, very often you do have a choice. Mutual funds are flexible investments from a tax standpoint. You, the investor, need to know all the tax aspects of mutual funds to make the right choices to minimize your tax obligations.

The year-end is a critical time for tax planning. Solomon Thompson, an IBM consultant who lives in New York, learned that lesson last December when he was about to put a lot of money into a mutual fund. His financial advisor urged him to wait until January to avoid paying 1994 taxes on the fund's December capital gains distribution. 'I saved a bundle on taxes," says Thompson. "Now I know to be careful when investing around year-end."

Being unfamiliar with the tax rules means you run the risk of having more of your wealth going to your silent partner in Washington.

Essentially, there are three ways to incur tax liabilities from mutual funds: capital gains distributions by the fund; dividend distributions by the fund; and capital gains arising from the sale or exchange of shares.

The funds are required to annually distribute all the capital gains and dividends that accrue within their portfolios. As we approach the end of the year, most stock mutual funds are preparing to make these distributions. If you own shares on the record date of the distribution, you will incur a tax liability for that distribution whether or not your own shares have appreciated.

But by carefully managing your position, you can have a significant impact on your tax bill. A good financial advisor can add value by helping you arrange your portfolio and implement strategies to lower your tax liability. Proper planning near the end of the year can be especially helpful, as Solomon Thompson now knows. Here's how you can achieve significant savings on your tax bill.

First, determine the mutual fund's intended distribution date and approximate payout by calling the fund's customer service 800 number (on your statement).

If you are connected to an online computer service, such as Prodigy, you can obtain the information directly online. If you are contemplating making a large purchase near year-end in a taxable, nonretirement account and the distribution is significant, you should probably put off the purchase by buying after the record date to avoid incurring an immediate tax liability. In a qualified tax-deferred retirement account, you can make the purchase at any time because you pay no taxes on distributions.

If you already own shares, then you can calculate whether it pays to sell them prior to this date and buy them back at a lower value the following day. Here's how: If the fund's net asset value is at or slightly below what you paid for it, and the pending payout is significant, then it pays to sell and avoid incurring a tax liability for that payout. If your shares have increased in value since you purchased them, and you have held them longer than one year, it may also pay to sell. Instead of paying a higher tax rate on the short-term capital gains dividend distribution, you can pay 28% on your longterm capital gains. Note, however, that if your shares have appreciated much more than the amount of the distribution, then it probably pays not to do anything and just pay the taxes on the distribution. That's because you would have to pay tax on the capital gain.

You may believe that once you sell or exchange shares the tax consequences are fixed. This is not so with open-ended mutual funds. The IRS gives you lots of flexibility in how you calculate your gains and losses, and each method has a different impact on your tax bill. Your accountant can be a great help here, but being informed of your choices ensures that you ask your accountant the right questions.

The IRS lets you choose from among four methods to calculate gains and losses on sales of mutual funds. Because you probably bought your shares at different times and at different prices, your tax liability could vary greatly depending on which shares you sell. For example, if you bought one share of XYZ Fund at $100, and a second share of the same fund a year later at $150, and a third share two years later at $200, and you want to sell a share a year later at $250, your taxable gain would vary tremendously depending on which share you decide to sell. If you sell the first share you acquired, you'd have a $150 capital gain, but if you sell the third share, your capital gain would be only $50.

The IRS allows you to choose how you want to account for such gains. The first method, called "first in, first out," or FIFO, is used by the IRS when an investor declines to choose any other. With this method, the oldest shares you hold (first in) are those considered sold first (first out.) The second method is called the single average cost method, whereby the average cost of all shares becomes the cost basis for any shares sold. The third method, or the double-average cost method, requires you to divide all shares owned at the time of sale into two categories, long- and short-term, and calculate an average cost for each category. The fourth method--almost always the most advantageous--is the specific identification method. Here you can choose which shares you elect to sell, so you can select the shares with the highest cost basis and realize the largest tax loss or the smallest gain possible, once again minimizing your tax bill. The election you make should be done in writing and confirmed by the fund; it cannot be altered thereafter. It should also be stated on your tax return.

"Using the specific identification method allowed me to minimize taxes on my fund share purchases that were made at different times," says Edward England, a New York City municipal employee.

Another simple technique for lowering taxes is to sell losing funds and offset taxable gains with these losses, or generate a deduction against other income. But be wary of the wash sale rule. The wash sale rule states that when you sell shares of a fund at a loss, the loss is valid for tax purposes only if shares of the same fund are not purchased within 31 days (before or after) the date of sale. To avoid the wash sale rule and still end up with shares of the fund you own, you can do one of three things: Repurchase shares sold 31 days after the date of the sale; double up and purchase an identical number of shares as your original investment 31 days before you sell; or sell the shares in a taxable account and immediately buy them back in a nontaxable retirement account.

Another alternative is to sell your shares, take the loss and purchase another fund that closely mirrors the objective of the first. This is commonly known as a "security swap." Morningstar publishes a statistic called the "Most Similar Funds," which can be useful in this regard.

The style of investing you choose may also influence your tax bill. Directing more money into growth funds with less-than-average turnover versus value funds with a high-income payout can help minimize taxes. The capital gains distributed by growth funds are often taxed at only 28% if the underlying securities were held by the fund longer than one year (a common characteristic of low turnover growth funds).

In addition, growth funds usually have a relatively low dividend distribution payout, typically 1% or less. Dividend income distributions, on the other hand, are taxed at the federal rates of up to a maximum of 39.6%.

Another way of helping to minimize your tax bill is to check how much unrealized capital appreciation is already built into a fund before you buy it. The amount of unrealized capital appreciation can be a rough indication of future capital gains distributions. Morningstar and Value Line investment surveys (available in your local library) list an approximated statistic for this value, which can also be found in annual and semiannual reports from the funds themselves. In general, the more unrealized appreciation in the fund, the greater the potential tax liability. Unfortunately, funds with excellent performance usually have a lot of unrealized appreciation.

A good example is the FPA Capital Fund, a small-cap value fund with an excellent long-term record. It has roughly a 33% unrealized appreciation in its portfolio, but to its credit the turnover ratio is low, about 15%. Because it may take a great while for the fund to distribute its gains, this is a good fund to hold from a tax perspective.

If you want to minimize your tax bill, you should familiarize yourself with the principles described here or be sure that your advisor knows them. But despite all tax implications, your own goals and risk tolerance level should be the main factors in your decisions to buy and sell mutual funds. Almost all studies conducted to date show that a long-term approach to staying in equities will serve the investor well over the long term. The tax aspects should be used more to modify and help time your decisions.