From an investment standpoint it is important to understand the differences between a savings account and a mutual fund. Savings accounts can be described as a loan to a financial institution, with that institution paying you interest for the use of your money. An investment in a mutual fund is a form of stock ownership from which you will have interest on cash balances, dividends from underlying stock and the mutual fund itself, capital appreciation or capital depreciation. It is important to be aware that the values of you mutual funds can decrease!

The remainder of this newsletter will focus on the tax aspects of mutual funds.

Annual Income

Mutual funds can make two types of taxable distributions, ordinary (dividend) or capital gain distributions.

Ordinary dividends come primarily from interest and dividends earned by the fund, but also include short-term capital gains as explained below. These distributions are reported as dividends and will be taxed as ordinary income on your return whether you actually receive the distribution or reinvest it in the fund.

Capital gains distributions come from a fund's net gains on the sale of securities. They may be short-term or long-term, depending on how long the fund owned the securities that were sold. Short-term capital gains distributions are included with dividends on your 1099 and taxed as ordinary income. Long-term capital gains distributions are treated as long-term capital gains, regardless of how long you have owned shares in the fund.

Sometimes a fund will make distributions in excess of the income it earns. This excess is called a return of capital. Because a return of capital represents a return of part of your investment, this distribution is not taxable. Your basis in the shares is reduced by the amount of the return of capital.

Ordinary dividends and capital gains distributions are taxable in the year they are declared, whether you actually receive the distribution or reinvest the income into the fund. In January, your fund will send you a Form 1099-DIV to tell you how each distribution should be reported on your tax return.

Tax Planning – Do not buy dividends

You should be careful if you are buying a mutual fund at year-end. If you purchase shares just before a dividend distribution, you will receive a portion of your investment back as a taxable distribution. This is because when a fund makes a distribution, the amount of the distribution is subtracted from the share price. You can avoid "buying a dividend" by waiting until after the distribution to invest.

Tax-exempt mutual funds

Dividends from U.S. Government funds are generally free from state income tax. Dividends from municipal securities are exempt from Federal tax and dividends from New York State Municipal funds are exempt from both Federal and New York tax.

International funds

If your fund invests in foreign stocks or bonds, some of the income it distributes may have had foreign tax withheld. If so, you may be entitled to a tax deduction or credit for your share of the taxes paid (the amount will be on your Form 1099-DIV). Normally, a tax credit will be claimed as it provides a dollar-for-dollar offset against your tax liability, while a deduction reduces the income on which you must pay tax.

Gain on sale of a fund

In addition to the taxes paid annually on the dividends and capital gains within the fund, when you sell your mutual fund shares you will usually realize a capital gain or loss. Your gain or loss will be the difference between the sales price and your basis in the shares. Your basis in the shares is normally the amount you paid for the shares, including income reinvestment. Many mutual fund families will calculate your basis for you, using an average cost approach.

If you don't sell all of your shares, you can choose between four different methods to calculate the cost basis: first-in, first-out (FIFO), average cost-single, average cost-double and specific identification.

FIFO: Under this method, the first shares bought are considered the first shares sold. FIFO is the default method unless another method is elected.

Average cost: This approach allows you to calculate an average cost for each share sold by dividing the total cost of all your shares by the number of shares held.

Specific identification: With the specific identification method, you specify which shares have been sold. On the day of the sale, you must identify the specific shares to be sold, and should maintain a written confirmation of the shares sold.

Wash sale rule

When selling mutual fund shares at a loss, you need to be careful of the wash sale rule. If you sell shares at a loss, you can't claim the loss if you purchased other shares of the same fund within 30 days before or after the sale. Again, most mutual funds will track the application of the wash sale rule.

Prudential Securities is developing an asset allocation model for especially for Barclays iShare exchange traded funds for a wrap program. The move is seen by experts who follow the development of ETFs as a further step towards legitimizing the asset class as a tool for long-term investors. Prudential has not given a date as to when the allocation model will be ready for use. One Prudential official said iShares, and ETFs in general, are ideal low-cost allocation tools because they are tax-efficient, provide broad diversification, and are resistant to style-drift.