A study of 17,000 stock mutual fund share classes by Standard & Poor’s, determined that fund expenses are a critical factor in fund performance.

The study found that over a ten-year period, stock funds with lower than average expense ratios performed better than funds with higher than average expense ratios in all investment style categories except one. The exception was the mid-cap blend category.

It is important for you to keep fund expenses in the forefront of your analysis when selecting funds for your portfolio.

Significance of tax planning

Tax planning will often result in substantial tax savings. If you use a calendar year for preparing and filing your tax return, your opportunity for tax planning will end on December 31. Therefore, with some exceptions, when you do prepare your tax return two to three months after the end of the year, it is generally too late to do anything.

Tax planning involves the timing and method by which your income is reported and your deductions and credits are claimed. In general, you should defer income into a subsequent year and accelerate deductions into the current year. You also need to consider if the income can be taxed when you are in a year with a lower marginal tax rate (marginal tax rate = highest rate that is applied in the tax computation for a particular taxpayer) and the deductions claimed in a year when you are at a higher marginal tax rate. For example, if you expect to be at a lower marginal rate , you should defer the receipt of income and accelerate deductions.

Three cardinal rules for tax planning:

• Defer tax whenever possible
• Recognize income when your marginal rate is low
• Pay deductible expenses when your marginal rate is high

Planning around your marginal tax rate

Controlling your marginal rate of tax rests in your ability to time your income and deductible expenses. Some other factors that may change your marginal rate of tax from year to year follow.

Filing status

There are four schedules of tax rates that apply to individuals. Two apply to married persons and two to single persons. For married persons, the choices are “married filing jointly” and “married filing separately.” On occasion, a married couple may be able to reduce their overall tax liability by filing separate returns. If separate returns are filed, each spouse reports his or her income and deductions on separate returns. Moreover, for tax purposes, your marital status is determined on the last day of the year.

Single people generally select “single” filing status. If a single person lives with and provides support for a dependent he or she may file as “head-of-household.” These rates are more favorable than the rates that apply for “single” status.

Income level

Your level of income will determine your marginal tax rate. Therefore, significant changes in income from year to year may present planning opportunities. A marriage or divorce can have a major impact on your level of income, as do job changes, retirement, inheritances, illness, and sale of investments.

Tax preference and adjustment items

So called “preference items” and “adjustment items” (some examples include: certain tax exempt interest income, incentive stock options, and certain itemized deductions) are relevant with regard to the Alternative Minimum Tax (AMT). The AMT is in place to make sure that you pay at least a minimum level of tax. Consequently, if your deductions are significant and/or you have taken advantage of too many other tax opportunities, some or all of the “preference items” and “adjustment items” may be disallowed or adjusted for purposes of the AMT calculation. The important thing for you to know at this time is that if you have significant deductions or preference/adjustment items, you may be subject to the AMT. If you are subject to this tax, you may be at a higher marginal rate than you anticipate. Because of this possibility, planning for the AMT is very important.

Conclusion

Tax planning is now much more than just deferring income and accelerating deductible expenses towards year-end. Major Tax Acts over recent years guaranteed lower tax liabilities for almost everyone. But with so many changes being phased in and out over the next several years, you will need a scorecard to keep it straight. Also, with many more options now available, tax-planning strategies should be considered year-round and not only towards year-end.

Based upon a study conducted by Lipper, Inc., owners of stock funds in taxable accounts give up an average of 1.98 to 2.50 percentage points in total returns to taxes annually.

There are some steps that you can take in order to mitigate the impact of taxes on your investments:

• Invest in index funds, particularly in taxable accounts. They usually have a buy and hold strategy, resulting in low turnover of fund holdings (lower capital gain distributions).

• Consider investing in tax-managed funds. These funds take an index-oriented approach and employ additional techniques, such as loss harvesting, and selecting higher cost-basis holdings when selling.

• Hold your less tax efficient funds, such as actively managed funds and taxable bond funds in tax-deferred accounts.

The new tax rates raise questions as to how your investments should be allocated between your taxable accounts and your tax-deferred retirement accounts (401(k), IRA). Under the new law, the highest marginal rate for qualifying dividends is 15% and also 15% for most long-term capital gains (owned for more than one year). The highest rate for ordinary income items (interest, short-term capital gains, wages) is 35%.

Previously, the conventional wisdom was to hold equities (stock) in taxable accounts and debt (bonds) in tax-deferred accounts. The new tax rates further strengthen this position for most investors. The reason for this is that qualifying dividends and most long-term capital gains will be taxed at a top rate of 15% and interest income from bonds will be taxed at a top rate 35%. As a result, you get the biggest savings by having your bonds in tax-deferred accounts.

With the new law in mind, you should decide on the allocation of stocks and bonds that are appropriate for your goals, time horizon, and risk tolerance. Then determine the allocation between taxable and tax-deferred accounts. Always keeping in mind that investment decisions should not be driven solely by tax considerations. Also, the lower rates on dividends and long-term gains are effective only through the end of 2008. What happens after that nobody knows at this time.

Mutual funds are priced once per day after the markets have closed. You can purchase and redeem shares through the funds directly.

ETFs are indexed vehicles that trade like stocks, are traded through a brokerage account throughout the day, and their prices fluctuate all day. Expense ratios are usually slightly lower. You will incur commissions for each transaction. If you invest regularly, this can be expensive.

In general, when choosing between the two, your preference for trading flexibility should take priority because expense ratios are marginally different.

ETFs are tax efficient compared to mutual funds. However, comparison for ETFs should be with tax-managed funds, which seek to maximize after tax returns.

The volatile markets have created tax-planning opportunities that you should consider as the year winds down.

Capital Gains/Losses

Your capital losses from the sale of investments will offset your capital gains. If your losses exceed your gains, the IRS allows you to deduct an additional $3,000 against other income and any unused losses may be carried forward to use in future years. For example, if you have losses from the sale of investments, consider selling (if selling makes sense within the context of your goals) investments with gains prior to year-end. The gains will be offset to the extent of your losses.

If you want to recognize both gains and losses in two different stocks, or mutual funds, the sale of each will allow you to offset the gains with the losses. If you really like the stock, or mutual fund, that you sold at a loss, you can repurchase a similar stock, or fund. To avoid the “wash sale” rules you must purchase a similar investment but not an identical one or the loss will be disallowed. When implementing such a strategy, you should also consider any associated transaction costs.

Mutual Funds

With regard to mutual funds, here are a few items that you should keep in mind. Funds usually distribute capital gains every year. The deemed distributions are taxable to the shareholders even though no cash has been received. Call your funds and ask about capital gain distributions for 2002. With this information, you can plan to implement some strategies prior to year-end. Also, if you are planning on selling or buying shares of funds, you need to know the dividend dates. If you are buying, you should purchase shares subsequent to the date. And if you are selling, you should sell prior to the date. With regard to a sale of shares, you also need to consider the different methods available in determining your basis. There are several methods and the method you elect can have a significant impact on the amount of gain or loss you need to report to the IRS.

Charitable Donations

Consider donating appreciated stock or mutual fund shares to a qualified charitable organization instead of cash. If done properly, you do not report any gain on the donation and you receive a charitable deduction equal to the fair market value of the investment. If you are considering donating an investment that has declined in value, sell it first, and donate the net proceeds, that way you will be able to deduct all or part of the loss in the year of the sale and receive a charitable deduction for the cash contributed.