TAX PLANNING GUIDE 2002/ A065977

Transcription

1 2002/2003 TAX PLANNING GUIDE Prudential Financial is a service mark of The Prudential Insurance Company of America, Newark, NJ, and its affiliates. August 2002 TAX100 A065977

2 Securities products and services are offered through Prudential Securities Incorporated, a Prudential company. Prudential Financial is a service mark of The Prudential Insurance Company of America, Newark, NJ and its affiliates.

3 Important Tax Deadlines For 2002 Tax Year (In chronological order) Last day to establish Monday, Sept. 30, 2002 a SIMPLE IRA Last day for doubling up to Friday, Nov. 29, 2002 avoid the wash sale rule Last day to buy in to close a Thursday, Dec. 26, 2002 short position in stock at a loss (regular way settlement)* Last day to buy in to close a Monday, Dec. 30, 2002 position in listed options at a gain or loss Last day for sale of stock Tuesday, Dec. 31, 2002 or listed options to realize gain or loss Last day to establish Tuesday, Dec. 31, 2002 a new qualified plan (calendar-year taxpayers) Last day to buy in to close a Monday, Jan. 27, short-against-the-box position (regular way settlement) Last day to establish and/or Tuesday, April 15, 2003 contribute to a 2002 traditional IRA or Roth IRA Last day to establish and Tuesday, April 15, 2003 contribute to a Coverdell Education Savings Account for 2002 Last day to establish Due date of employer s tax and/or fund a SEP IRA return, including extensions Last day for employer to Due date of employer s tax fund a SIMPLE IRA or return, including extensions an existing SARSEP IRA *For short sales closed out at a gain, see page 8. For lifetime required minimum IRA distributions, see page 31. Remember that the trade date will generally determine the year in which a transaction is taxed. Therefore, any trade occurring after December 31, 2001, and on or before December 31, 2002, whether for a gain or for a loss, will generally be taxed in Prudential Securities Incorporated, all rights reserved.

4 Important Tax Deadlines For 2003 Tax Year (In chronological order) Last day to establish Tuesday, Sept. 30, 2003 a SIMPLE IRA Last day for doubling up to Friday, Nov. 28, 2003 avoid the wash sale rule Last day to buy in to close a Friday, Dec. 26, 2003 short position in stock at a loss (regular way settlement)* Last day to buy in to close a Tuesday, Dec. 30, 2003 position in listed options at a gain or loss Last day for sale of stock Wednesday, Dec. 31, 2003 or listed options to realize gain or loss Last day to establish Wednesday, Dec. 31, 2003 a new qualified plan (calendar-year taxpayers) Last day to buy in to close a Tuesday, Jan. 27, short-against-the-box position (regular way settlement) Last day to establish Thursday, April 15, 2004 and contribute to a Coverdell Education Savings Account for 2003 (formerly Education IRA) Last day to establish and/or Thursday, April 15, 2004 contribute to a 2003 traditional IRA or Roth IRA Last day to establish Due date of employer s tax and/or fund a SEP return, including extensions Last day for employer to Due date of employer s tax fund a SIMPLE or return, including extensions an existing SARSEP *For short sales closed out at a gain, see page 8. For lifetime required minimum IRA distributions, see page 31. Remember that the trade date will generally determine the year in which a transaction is taxed. Therefore, any trade occurring after December 31, 2002, and on or before December 31, 2003, whether for a gain or for a loss, will be taxed in Prudential Securities Incorporated, all rights reserved.

5 2002 Tax Information Mailing Schedule (In chronological order) Form 5498 December Statement Fair market value of your Individual Retirement Account (IRA) Consolidated Statement & No later than Form 1099-DIV* January 31, 2003 Dividends & Other Distributions Form 1099-INT Reportable Interest Income Form 1099-OID Original Issue Discount income (other than CMO/REMIC instruments) Form 1099-B Proceeds of sales, redemptions & tenders Form 1099-MISC Royalties & miscellaneous income Form 1099-R No later than Distributions from your IRA January 31, 2003 and other retirement accounts Form 1099-OID (REMIC) March 17, 2003 OID & interest accruals from CMOs/REMICs Schedule K-1 March 17, 2003 Master Limited Partnership (MLP) income, which will be mailed to you directly from the General Partner Form 5498 June 2, 2003 Contributions, rollovers to your IRA Form 5498 June 2, 2003 Contributions to a Coverdell Education Savings Account *Since many distributions on Form 1099-DIV are reclassified after year-end, we strongly urge you to wait for these documents before preparing your returns. For mailing dates of tax forms not listed above, please contact your Financial Advisor Prudential Securities Incorporated, all rights reserved.

6 Introduction...1 PART I Tax Treatment of Securities Transactions 1. Capital Gains and Losses...2 a) Portfolio Allocation...4 b) When to Recognize Capital Gains...5 c) Choosing Recognition This Year...5 d) Postponing Recognition Until Next Year Multiple Lots: Identification of Securities Transactions Mutual Funds...11 a) Distributions...11 b) Sale, Redemption or Exchange of Fund Shares Options...16 a) Listed Call Options...17 b) Listed Put Options...19 c) Listed Index Options...20 d) Collars Tax Treatment of Interest Expense...24 PART II Retirement Accounts and Plans 1. Types of Retirement Accounts and Plans...27 a) Traditional Individual Retirement Account (IRA)...27 I. Contributions...27 II. Contributions after III. Distributions...29 IV. Rollovers...31 b) Roth IRA...32 I. Contributions...32 II. Distributions...33 III. Rollovers...33 c) Simplified Employee Pension Plans (SEPs)..34 d) Savings Incentive Match Plan for Employees (SIMPLE)...35 I. Contributions...35 II. Distributions...36 e) Employer-Sponsored Qualified Plans...36 I. Contributions...36 II. Plans for Partners, Sole Proprietors and Self-Employed...39 III. Distributions...40 IV. Lump Sum Distributions...41 V. Distributions of Employer Stock Rollover or Taxable Distribution?...42 PART III Saving for Higher Education 1. Section 529 Plan...44 a) Contributions...44 b) Distributions Coverdell Education Savings Account (formerly Education IRA)...45 a) Contributions...45 b) Distributions Custodial Accounts...47 PART IV Other Tax-Advantaged Investments 1. Municipal Bonds Treasury, TIPS, U.S. Agency Securities and Stripped Obligations Tax Considerations for Bonds...52 a) Original Issue Discount...52 b) Market Discount...53 c) Premium Tax-Exempt Trusts Tax-Exempt Mutual Funds Tax-Deferred Annuities...56 PART V Financial Planning Considerations 1. Tax Strategies for Minors...60 a) Kiddie Tax Rules...60 b) Portfolio Allocation...60 c) Income Shifting to Custodial Accounts Estate Planning...61 a) The Unified Credit and the Marital Deduction...64 b) Life Insurance...65 c) Lifetime Asset Transfers...67 d) Strategic Gifting...68 PART VI Other Tax Information 1. Exemptions and Deductions...71 a) Personal and Dependent Exemptions...71 b) Itemized Deductions...71 c) Standard Deductions Exclusion of Income from U.S. Savings Bonds The Alternative Minimum Tax Income Tax Rates...74

7 Introduction Since taxes can reduce the effective yield of your portfolios, tax planning should play an important role in your comprehensive investment strategy. This guide offers helpful tips and investment ideas to help you maximize the after-tax return from your investments. Note that the Economic Growth and Tax Relief Reconciliation Act of 2001 contains a sunset provision. The sunset provision specifies that all provisions of and amendments made by the 2001 Act do not apply after December 31, 2010 in the absence of Congressional action. Therefore it is critical to confer with your tax advisor as to the potential impact of the sunset provision on your tax decision. Of course, you should carefully consider your tolerance for risk as well as your overall financial goals before making any investment decisions. Remember that comprehensive planning entails both tax and financial considerations. The Tax Services Group has enhanced the Tax Planning Guide to highlight both tax opportunities and pitfalls, which appear as and, respectively. As you review the Tax Planning Guide, note the tax opportunities and pitfalls as you invest throughout the year and plan for the years ahead. The Tax Planning Guide also features tax strategies particularly applicable to the end of the year. The Tax Services Group of Prudential Securities has prepared the Tax Planning Guide for informational purposes only. Prudential Securities is neither a tax advisor, legal advisor, nor an estate planner. You should consult your personal tax advisor before making tax-related investment decisions. However, your Financial Advisor can work closely with you and your tax advisor to help you reach your investment goals. The Tax Planning Guide addresses only federal tax law. Always consult with your tax advisor on the state and local as well as federal tax consequences of your investment decisions. 1

8 PART I Tax Treatment of Securities Transactions One of the most important parts of successful investing is understanding how specific securities transactions will be treated for tax purposes. Not only is it necessary to know this information when filing your tax return, but it is vital to consider when investing throughout the year. Refer to the following information whenever you invest in securities, with the goal of maximizing your after-tax return. 1. Capital Gains and Losses Capital gains and losses result when you sell capital assets such as stocks, bonds, options, precious metals and other commodities. You can determine capital gains and losses by comparing the difference between the proceeds you received upon the sale of the asset and the tax basis (adjusted cost) of the asset sold. The tax treatment of your capital gains and losses generally depends on how long you hold the asset before selling it. Gains and losses from sales of assets held for one year or less are considered shortterm and are taxed at ordinary income tax rates. An investor who purchases an investment on January 10, 2002 and sells it on January 10, 2003, exactly one year later, recognizes short-term gain or loss. There are several long-term capital gains tax rates. The 20% maximum capital gains tax rate applies to sales of assets held for more than 12 months (10% for those in the 15% or lower tax bracket). The 25% rate applies to depreciation recapture for certain real estate. Beginning in 2001, you can plan to benefit from a lower long-term capital gains rate. For assets purchased after the year 2000 and held for more than five years, the capital gains tax rate decreases from 20% to 18%. If you acquired the asset before 2001, 2 you may have made a special election to have future gains qualify for this lower rate. If you made this election, you would treat the asset as sold on January 1, 2001 and repurchased, recognizing any capital gain, but not loss. For taxpayers in the 15% or lower tax bracket, gains on securities held for more than five years (regardless of when acquired) will have a maximum capital gains tax rate of 8%. Regulated futures contracts, non-equity options and certain foreign currency contracts have different rules. For these capital assets, gains and losses are treated as 60% long-term and 40% short-term, regardless of the length of time held. Unlike other capital assets, these positions held at year-end are marked to market and treated for tax purposes as if they were sold for their fair market value on the last day of the year. Consult your tax advisor on the taxation of security futures contracts. Netting rules: To calculate your year-end capital gains and losses, follow these steps in the order listed: 1) Determine net gains and losses within each capital gains tax rate. For instance, net shortterm capital gains is netted against net shortterm capital losses. 2) Offset your net long-term losses against each category of long-term gains. Start with the long-term gains subject to the highest capital gains tax rate, and then proceed to the next highest long-term tax rate, ending with shortterm capital gains. For example, offset your net long-term 20% loss first against any net 25% gain, then net short-term gains. Any short-term capital loss carryovers from previous years are treated as short-term. Long-term capital loss carryovers are treated as long-term capital losses. 3

9 You may use net capital losses to offset up to $3,000 of ordinary income per year. Excess capital losses may be carried over to succeeding tax years until used. A COMMAND SM Account, our central asset account, can be an important tool in your investment planning process. Your COMMAND statement provides timely information on both realized and unrealized gains or losses. While not an official tax document, it can help you and your tax advisor make crucial investment decisions regarding the securities you own. Ask your Financial Advisor for more information on COMMAND Accounts. He or she can provide you with a free COMMAND Funds prospectus containing more complete information, including all charges and expenses. Please read it carefully before you invest or send money. a) Portfolio Allocation With long-term capital gains tax rates for assets held more than 12 months as low as 20% (and 10% for taxpayers in the 15% or lower bracket), your portfolio allocation of growth and income investments becomes significant. Similar to interest earned on municipal obligations, certain assets held in a potentially tax-free Roth IRA generate a higher effective taxable equivalent yield. Similarly, income-producing assets held in a traditional IRA or qualified plan that is tax-deferred produce a higher effective yield. Accordingly, consider allocating income-producing assets subject to ordinary income-tax rates (i.e., dividends, interest and short-term capital gains) to a traditional IRA, qualified plan or Roth IRA. By contrast, consider allocating growth investments, which usually generate long-term capital gains, to taxable accounts in order to benefit from the lower capital gains tax rates. Assets held in an IRA or qualified plan do not benefit from the lower capital gains tax rate or a step-up in basis upon death. 4 b) When to Recognize Capital Gains You may wish to postpone recognition of gains until next year and thereby postpone the tax liability. Conversely, you may decide that it is more beneficial to recognize capital gains during the current year. You may want to recognize capital gains this year if: The gains will be subject to a higher rate of tax next year due to a change in tax bracket or tax law. It is a sound investment decision. Recognizing gains when you have sufficient losses may allow you to recognize those profits tax-free. c) Choosing Recognition This Year If you recognize capital gains or losses this year, keep the following in mind: Wash sales. If you sell a security and realize a loss, the loss will be disallowed for tax purposes if a substantially identical security or an option to buy that security is acquired within 30 days before or after the sale. These rules also apply to the purchase and sale of substantially identical stock options. For example, selling a share of stock on October 1, 2002 and buying identical shares on or before October 31, 2002 or after August 31, 2002 would trigger a wash sale. Although the loss from a wash sale is not immediately recognized, it is added to the basis of the repurchased security. In addition, the holding period of the security sold at a loss is added to the holding period of the newly acquired security. As a result, the loss is deferred until the sale of the reacquired security. However, the loss will be allowed in the year of sale if the repurchased security is similar but not substantially identical to the security sold at a loss. (See the section on tax swapping on page 6.) The fact that the securities are issued by companies in the 5

10 same business, are selling at the same price, and exhibit similar market movement does not necessarily make them substantially identical. Entering into an option to acquire substantially identical securities within the 61-day period (30 days before or after the sale) will be treated, for wash sale purposes, as if the underlying securities were actually acquired (the prior loss will be deferred). Writing (selling) a put should not defer a loss on the prior sale of the underlying stock unless the put is exercised within the 30-day period. (If the put were exercised, the person who wrote the put would be required to repurchase the stock at an exercise price rather than the prevailing market price. For more detailed information on options, see page 16.) However, if the put is in the money, you should make sure that the strike price of the option is kept within a reasonable range. If it is not, the IRS may determine that there was a substantial likelihood the put, if deep enough in the money, would be exercised and is, in substance, a contract to purchase the stock sold at a loss. One way to prevent a wash sale is to double up on your shares, wait 31 days, and then sell and identify the original position. This will result in an allowable tax loss and continued ownership during the 31-day waiting period. The last day that you can double up and still meet the 31-day waiting period for 2002 is November 29, 2002 (for 2003, the last day is November 28, 2003). It is essential that you specifically identify the position you are selling. The wash sale rule does not apply to gains. Taxpayers who want to realize gains this year may reestablish their positions immediately. Tax swapping. If you own a depressed stock and there is a stock within that industry that your Financial Advisor believes will outperform your current holding, you may consider a tax swap. (Tax swaps may also apply to bonds, unit trusts or other financial instruments.) This may allow you to upgrade your portfolio and generate tax losses at the same time. The capital losses generated from a swap directly offset realized capital gains. 6 If you have realized capital gains a profit from the actual sale of a security, as opposed to an unrealized or paper profit you should make a special effort to examine your portfolio before year-end. There are several other advantages to a tax swap. You are not vulnerable to price fluctuations that may occur during the 31-day wash sale waiting period, your income is uninterrupted, and you get an opportunity to upgrade your portfolio while prices are still at a depressed level. For example, by switching from a depressed bond to a bond of a different issuer, you may be able to obtain a higher yield on your bond holdings or generate cash for other purposes. As an additional benefit, you may generate a capital loss for tax purposes. If you haven t recognized capital gains by that time, you may still want to recognize the loss to offset future gains. This is known as tax-loss harvesting. The following are a few investments to consider swapping: Common stock. In many cases, common stocks within the same industry rise or fall in unison. Naturally, some stocks within an industry will go up or down in price faster than others. The sale of one stock and the purchase of another within the same industry is not considered a wash sale for tax purposes. Mutual funds. If you own mutual fund shares, you may be able to create a tax loss by exchanging them for shares of another fund, even within the same fund family or sector. Please note that if within 30 days you swap back into the same fund in which you incurred a loss, you will be subject to wash sale rules. (See previous definition of wash sales, page 5.) Unit investment trusts. These include tax-exempt and taxable unit investment trusts, which are professionally selected, nonmanaged investment portfolios. Please note that if within 30 days you swap back into the same trust or underlying securities in which you incurred a loss, you will be subject to wash sale rules. 7

11 Municipal bonds. In a rising interest-rate environment, some municipal bonds may decrease in price and may be ideal candidates for tax-loss swapping. Consider using the losses on these bonds to offset capital gains elsewhere in your portfolio. The opportunity to upgrade your portfolio or to obtain higher yields on the reinvestment of funds into other similar municipal bonds may present itself when swapping in this environment. You can effect a bond swap in a period of falling interest rates as well. The capital gains incurred may be offset by other losses in your portfolio. Even though the bonds you may subsequently swap into may have a lower interest rate, you may benefit from an increase in credit quality or an extension of your call protection. No matter which direction rates are headed, you may use bond swapping to enhance the performance of your portfolio and to make sure your investments meet your financial objectives. (For more information on municipal bonds, see page 48.) d) Postponing Recognition Until Next Year If your financial objective is to postpone the recognition of capital gains or losses until next year, consider the following strategies: Rules for short sales. If you anticipate a decline in the value of certain stock that you do not own, you can enter into a short sale of the stock. In a short sale, you borrow shares of stock with the obligation of returning identical stock to the lender. After selling the borrowed stock on the open market, you do not recognize gains until you purchase identical shares at a lower price. If the stock becomes substantially worthless, you recognize a gain as if the short sale closed. Short-against-the-box. The short-against-thebox strategy that allowed you to enter into a short sale for stock you already own and postpone your capital gains while locking in the current market value as your sales price has been effectively eliminated. Capital gains may be postponed to the next year if you qualify under an exception by closing the short sale with newly purchased stock within 30 days after the close of the tax year of the short sale and by holding the original appreciated stock unhedged for at least 60 days after the short position is closed. Please consult with your tax advisor. Options. There are option strategies available to postpone gain recognition. For additional information, consult your Financial Advisor. Collars. Certain collars may be used to hedge appreciated stock. (For more information on collars, see page 21.) 2. Multiple Lots: Identification of Securities Transactions By specifically identifying the most tax-efficient lot at the time of sale, you can determine in advance the amount of gain and loss to recognize and whether it is short-term or long-term. When various lots of the same security are bought and sold at different times and at different prices, the ability to identify the specific securities sold creates a tax-planning opportunity. If you do not specifically identify the lot (or lots) of securities to be sold, Treasury regulations impose the firstin, first-out (FIFO) method of identification. This means that the securities sold are deemed to be the securities held by you for the longest time. However, any securities that are specifically identified can be designated as the ones sold. The following rules should be kept in mind and discussed with your Financial Advisor when selling any securities: If the stock is registered in Prudential Securities name, a specific identification is made by informing 8 9

12 your Financial Advisor of the particular stock to be sold. Your written confirmation from Prudential Securities should reflect which stock was sold. If you hold a single stock certificate representing ownership of stock bought at different times, specific identification is made by instructing your Financial Advisor about which stock to sell when delivering the certificate and receiving a written confirmation. If the identity of the lot can be established by certificate number, you must deliver the certificates you want to sell, because the certificates actually delivered will be the lot sold. For mutual funds only: As an alternative to the regular methods of determining cost basis, a mutual fund investor may opt to use one of two average basis methods if shares in the same mutual fund were acquired at various prices and remain on deposit with the fund custodian. Which method you use to determine cost will determine if you can specifically identify the lot to be sold to create short-term or long-term gains and losses. See page 15 for further discussion. If you have inherited securities, the ability to identify in advance which security is sold also creates a tax-planning opportunity. Securities that have been inherited generally receive a cost basis equal to fair market value on the date of death (or alternatively, six months after death in certain circumstances). This usually results in an increased cost basis, referred to as a stepped-up basis. If the security has gone down in value, this lower value generally becomes the cost basis and is referred to as a stepped-down basis. In addition, inherited securities are automatically considered to be held longterm, regardless of how long they are actually held before or after sale. Remember to notify your Financial Advisor of your inherited lots, to ensure an accurate reflection of your basis and holding period. The security identification rules can be helpful in connection with your year-end tax planning. For example, let s say that on December 2, 2002, you hold the following positions in ABC common stock: Purchase Date Position Cost 5/12/ $50 $5,000 7/24/ $60 $6,000 Assume that ABC common stock is selling for $58 a share. On December 3, 2002, you can create either a gain or a loss on the sale of a portion of your ABC shares by specifically identifying the lot sold. Sale of 5/14/00 lot: long-term 20% capital gain of $800 Sale of 7/24/02 lot: short-term capital loss of $200 As this example illustrates, specific identification of the securities sold is important in determining the tax consequences of the sale. 3. Mutual Funds a) Distributions Distributions from a mutual fund consist of ordinary dividends and capital gains distributions. With the exception of the tax-exempt mutual funds discussed on page 55, dividends received from mutual funds are taxable. Like most investments, their taxability largely depends on how the proceeds are distributed. When investing in mutual funds, check the funds ex-dividend date and delay late-in-the-year mutual fund investments until after the fund s ex-dividend date. (For some funds, the ex-dividend date may also be the record date.) Otherwise, the most recently declared dividend will be credited and taxable to you. In effect, part of the money you invested will be returned to you immediately as taxable income

13 Several types of distributions may be received from a mutual fund. An ordinary dividend is a distribution of currently taxable earnings (including short-term capital gains) and is treated as dividend income on your tax return. Since the short-term capital gains distributed from the mutual fund is treated as a dividend, it cannot be offset by capital losses realized from other investments. Most states do not tax the portion of fund dividends attributed to interest from federal obligations. The amount is passed through to shareholders as a percentage of their dividends. Certain states, such as New York, California and Connecticut, require that the fund hold a certain minimum percentage of federal obligations before treating a portion of the income passed through to shareholders as exempt from state tax. In addition, states generally do not tax obligations issued by that state and/or its municipalities. Check with the fund at year-end for the anticipated percentage of income attributable to federal obligations, as well as those issued by your state and/or its municipalities. Capital gains distributions are paid from long-term capital gains realized by the mutual fund and should be reported by you as long-term capital gains on Schedule D (Form 1040), regardless of how long you have owned shares in the mutual fund. Year-End Tax Planning: Consider selling investments trading at a loss to offset some or all of the mutual fund capital gains distributions. In some situations, instead of distributing the capital gains, the mutual fund may keep its long-term capital gains and pay taxes on that income. If so, the fund will send you Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains, showing the undistributed capital gains and any tax paid. You must report as long-term capital gains any amounts 12 that the mutual fund allocated to you as a capital gains distribution. If the fund has paid a tax on the capital gains, you are allowed a credit for the tax because it is considered to have been paid by you. Be sure to attach Form 2439 to your Form 1040 in filing your return. Increase your cost basis in the shares by the difference between the undistributed capital gains that you report and the tax paid for you by the fund. Long-term capital gains distributed by the fund are taxable at the appropriate capital gains rate of 20% (versus the maximum tax rate of 38.6% for 2002 and 2003 on taxable ordinary dividends). Investors who wish to take advantage of the lower long-term capital gains tax rates may consider investing in growth-oriented mutual funds with low turnover. Mutual funds that hold assets longer may make capital gains distributions subject to the lower long-term capital gains tax rate. Especially if you are in a high tax bracket, you may also wish to consider tax-efficient or tax-managed mutual funds, which are specifically managed to minimize taxable distributions and maximize long-term growth within the fund. Conversely, mutual funds with significant net shortterm capital gains are better suited for tax purposes in a tax-deferred account. A fund may make a distribution that is greater than its earnings and profits. This type of distribution is considered a return of your investment capital and is not taxable. The information is reported on Form 1099-DIV and should appear on your tax return as a nontaxable distribution that reduces your basis in the fund accordingly. To the extent that a return of capital distribution exceeds your basis in the shares, the excess is treated as either a long-term or short-term capital gain, depending on your holding period of the mutual fund. 13

14 Corporate shareholders may qualify for a 70% dividend received deduction on dividends the fund receives from investing in U.S. corporations. The fund will notify its shareholders about the percentage of the dividends qualifying for the dividend received deduction. This rule does not apply to Subchapter S corporations. Mutual funds that invest in foreign stocks and securities may elect to pass through the foreign taxes paid on the securities to you if the fund meets certain requirements. If the mutual fund elects to do this, the foreign taxes may be added to the dividends paid and you will be allowed to take a tax credit or a deduction of the taxes paid against your U.S. tax liability. Neither the foreign tax deduction nor credit applies to investments held in a tax-deferred account. Spillover Dividends: Dividends declared by mutual funds in October, November or December, payable to shareholders of record on a specified date in such a month, and actually paid the following January are taxable in the year in which they are declared. b) Sale, Redemption or Exchange of Fund Shares As with individual stocks, the sale or redemption of mutual fund shares generate taxable gain or loss for the shareholder. The sale or exchange is taxable, even if the fund invested in tax-exempt obligations. Cost basis. If you sold, redeemed or exchanged fund shares during the past year, you will need to figure out the gain or loss from the transaction for income tax purposes. This is done by comparing your cost basis in the shares sold to the selling price. There are several ways to determine your cost basis. You can use the cost paid for each separate investment lot and/or reinvestment lot, or you may elect an average cost-basis method. Once you select an average cost method for a particular mutual fund, you 14 cannot change that method. However, you are entitled to use a different cost-basis method for each mutual fund you purchase. Your choice of method for determining cost is important, since the most tax-efficient method chosen, according to your circumstances, may significantly reduce the tax impact on your sale of shares, if or when you choose to lighten up your holdings in a particular mutual fund. If you decide to use an average cost method, you may use either the average cost-single category or average cost-double category. Under the average cost-single category, your cost per share is determined by aggregating the cost of all shares. Under the average cost-double category, your cost per share is determined by separating the shares into two categories: short-term and long-term. You then calculate an average cost for each category. Selecting which shares to sell. You may have multiple shares in a mutual fund that you acquired over time by direct purchases and/or by dividend reinvestment programs. Some of these shares may be held shortterm and some may be held long-term. In addition, if your cost basis is determined by using the price paid for each share, each lot has a different cost basis. The ability to identify which shares are sold may present a tax-planning opportunity. If you do not adequately identify which lot is sold, the first-in, first-out method (FIFO) is used. However, under the specific identification method, any shares that are specifically identified can be designated as the ones sold. However, specific identification is not available if you have determined your cost basis using the average cost-single category method. For a detailed discussion of identification of securities transactions, refer to page 9. Sale before ex-dividend date may prevent paying tax at higher ordinary income tax rates on long-term holdings. If you plan to redeem mutual fund shares that 15

15 have gone up in value, consider doing so before any upcoming dividend ex-date. If you have owned the shares for more than one year, you ll pay tax on your gains at the more favorable 20% long-term capital gains rate instead of paying tax on any dividends at higher ordinary income tax rates. On the other hand, selling out of a fund after the ex-dividend date may benefit you if you realize ordinary income distributions to offset investment interest (see page 24). Sale within six months. The holding period of your mutual fund shares is also important for other reasons. If you sell shares that you ve held for six months or less, and in that time you received a capital gains dividend or were credited with an undistributed long-term capital gains, any loss on the sale is treated as a long-term capital loss, up to the amount of the capital gains dividend. In addition, if you receive an exempt interest dividend on your shares and the shares were held for six months or less, any loss on the sale of such shares, up to the amount of the exempt interest dividend, is disallowed. Don t buy shares in the same mutual fund in which you sold your shares at a loss within 30 days, since the wash sale rules will effectively defer the loss until you sell the new shares. 4. Options For tax purposes, options are generally treated as capital assets. Forms 1099 are not issued for option transactions. However, you are still required to account for these transactions, on your return. Options are not suitable for all investors. Your Financial Advisor can provide you with the Options Disclosure Document, titled Characteristics and Risks of Standardized Options, or log onto to locate a branch near you, where you can obtain a copy. You can also write to our Prospectus Distribution Department at 111 Eighth Avenue, New York, NY for a copy. 16 Heads up for year-end tax planning: Don t forget that option transactions can give rise to gains or losses that you may use to net against other gains or losses in your portfolio. The following describes the general tax treatment of listed call, put, and index options. The charts on pages summarize these rules. a) Listed Call Options A call is a right, but not an obligation, to purchase a security at a specified price within a specified time period. If you purchased call options and sold them during the current year, you realize a short-term capital gain or loss on the closing sale. The expiration of an unexercised long call option in the same year of purchase results in a short-term capital loss. No gain or loss is realized upon the exercise of a long call option. Instead, a capital gain or loss is realized when you sell the stock acquired by exercising the call. The cost of the call is added to the purchase price of the stock to compute gain or loss. The holding period for the stock begins the day after the call option is exercised, not the date the call is acquired. (You don t add on the holding period of the option.) If you write (sell) calls and repurchase your call options, you realize a short-term capital gain or loss on the closing transaction. If the short call option expires unexercised, you will realize a short-term capital gain. If you write calls and the call options are exercised, you will realize a capital gain or loss. To determine the amount of capital gain or loss, add the premium received for writing the call to the selling price of the stock. If you purchase a call option within 30 days of selling the underlying security at a loss, you will incur a wash sale. (Please see page 5.) Covered call option writing. Writing a call will not affect the holding period of underlying equity positions already held for more than 12 months. Writing a covered call that does not meet the criteria of a 17

16 qualified covered call (discussed below) terminates the holding period of short-term equity positions. In such a case, the holding period of the equity position will not commence until the call is closed or expires. Writing an out-of-the-money or at-the-money qualified covered call does not affect the holding period of short-term equity positions. On the other hand, an inthe-money qualified covered call merely suspends the holding period of short-term equity positions. The holding period will continue to run once the call is closed or expires. Consult with your tax advisor on the effect of writing LEAPs on the holding period of underlying stock. Generally, a qualified covered call must meet the following conditions: The call option is covered by an underlying long position. The call must be traded on a national securities exchange registered with the SEC or other market approved by the Treasury. The call must be granted more than 30 days before it expires. The call is not deep-in-the-money (as defined for tax purposes) at the time the call is written. The call is held as a capital asset, resulting in capital gains treatment. Long-term options with expirations of up to three years, known by the acronym LEAPS, provide the purchaser with the potential to achieve long-term capital gains or losses. Specifically, the gain or loss attributed to a LEAPS that you purchased and then held for over a year is long-term. However, if you write (sell) a LEAPS, any gain or loss attributed to a LEAPS that you wrote will always be treated as short-term, even if the expiration is more than one year. The holding period of stock held for over a year remains unaffected. 18 Caution: The IRS has the authority to treat the writing of an in-the-money call option as a constructive sale if it eliminates substantially all of the risk of loss and opportunity for gain to the investor. To date, however, the IRS has not yet issued any regulations governing these transactions. Please consult your tax advisor for more information. b) Listed Put Options A put option is a right, but not an obligation, to sell a security for a specific price within a specified time period. Purchasing an option does not by itself cause a taxable event. If you purchased put options and sold them during the current year, you will realize a short-term capital gain or loss on the closing sale. The expiration of the long put options in the same year of purchase results in a short-term capital loss. Protective put option purchases. Purchasing a put when the underlying stock is held short-term will terminate the holding period on the stock. Purchasing a put will not affect the holding period of underlying equity positions already held for more than 12 months. For buyers of puts, the exercise of a put constitutes a sale of the underlying stock. The cost of the put is subtracted from the selling price of the stock in computing capital gain or loss. The date of exercise of the put option is treated as the sale date of the stock for tax purposes. If you write puts and repurchase their put options, you will realize a short-term capital gain or loss on the closing. If the option expires unexercised, you will realize a short-term capital gain. For writers of puts, the exercise of the put is a forced purchase of the stock and is not a taxable event. The put writer deducts the premium received for writing the put from the purchase price of the stock. The holding period for the stock begins on the day after the date of exercise. 19

17 Long-term options with expirations of up to three years, known by the acronym LEAPS, provide the purchaser with the potential to achieve long-term capital gains or losses. Specifically, the gain or loss attributed to a LEAPS that you purchased and then held for over a year is long-term. However, if you write (sell) a LEAPS, any gain or loss attributed to a LEAPS that you wrote will always be treated as short-term, even if the expiration is more than one year. Caution: The IRS has the authority to treat the purchase of an in-the-money put option as a constructive sale if it eliminates substantially all of the risk of loss and opportunity for gain to the investor. To date, however, the IRS has not yet issued any regulations governing these transactions. Please consult your tax advisor for more information. c) Listed Index Options Listed index options represent an underlying market index instead of a specific stock. When an index option is exercised or expires, it is settled by the payment of the cash difference between the closing price of the index on the day of exercise or expiration and the strike price of the option. If you want to speculate on the direction of the market, as represented by an underlying index, you can purchase a call or put option on that specific index. Index put options can also be purchased to hedge an existing portfolio of securities, including diversified mutual funds. Options with expiration periods ranging from one month to several years (LEAPS) are available on such indexes as the S&P 100, S&P 500, and the ASE Major Market Index. Certain index options, such as options on the NYSE Index and the S&P 500 Index options, settle on the basis of the settlement value on the expiration day. A broad-based index comprises a group of stocks that reflect the performance of the entire market. A narrow-based index measures the performance of a particular market segment or industry group. The major tax difference between broad-based index options and equity options is that with broad-based index options, any gain or loss, regardless of the holding period, is treated as 60% long-term capital gain and 40% short-term capital gain. Heads up for year-end tax planning: Broad-based index option positions are marked to market at yearend and treated for tax purposes as if they were sold for their fair market values on the last day of the year. Narrow-based options are not taxed until the lapse or closing transaction. Futures and options traded on foreign exchanges may be subject to different tax treatment. If a sufficient overlap exists between a broadbased index option and a mutual fund or other investment, they may both constitute substantially identical securities for wash sale purposes. Consult with your tax advisor. d) Collars In a collar transaction, you simultaneously buy a put and sell a call option on appreciated stock you already own (long position). This stock is called the underlying stock. The cost of the put is usually reduced or eliminated by the premium received from the call. The collar provides full downside protection on the long position below the exercise price of the put option and allows you to participate in the price appreciation up to the exercise price of the call option. Caution: The IRS has the authority to treat a collar as a constructive sale if it eliminates substantially all of the risk of loss and opportunity for gain to the investor. To date, however, the IRS has not yet issued any regulations governing these transactions. Please consult your tax advisor for more information

18 Tax Consequences to Buyer: Equity Options Transaction Put Call Opening Closing Lapse/expiration Exercise -No loss or deduction upon payment of premium. -If covered with short-term stock: holding period of stock terminated. -If covered with long-term stock: no impact on holding period. -Gain or loss is short-term. Gain or loss is long-term for LEAPS held for over a year. -If covered, holding period of short-term stock begins. -Loss is short-term. Loss is long-term for LEAPS held for over a year. -If covered, holding period of short-term stock begins. -Gain or loss. Subtract premium from selling price. -Holding period as per underlying stock. -No loss or deduction upon payment of premium. -Gain or loss is short-term. Gain or loss is long-term for LEAPS held for over a year. -Loss is short-term. Loss is long-term for LEAPS held for over a year. -No current tax impact. -Increase stock basis by premium. -Holding period begins day after exercise. Tax Consequences to Seller: Equity Options Transaction Put Call Opening Closing Lapse/expiration Exercise -No income or gain upon receipt. -Gain or loss is short-term (for LEAPS as well). -Gain is short-term (for LEAPS as well). -Premium subtracted from basis. -Holding period begins day after exercise. -No income or gain upon receipt. -If covered with long-term stock: no impact on holding period. -If covered with short-term stock and at-themoney or out-ofthe-money: no impact on holding period if qualified covered call; otherwise terminated. -If covered with short-term stock and in-themoney, the holding period is suspended if qualified covered call; otherwise terminated. -Gain or loss is short-term (for LEAPS as well). -Gain is shortterm (for LEAPS as well). -Gain or loss. Premium added to sale proceeds. -Holding period as per underlying stock. (See above for opening transaction) 22 23

19 5. Tax Treatment of Interest Expense Interest expense incurred (other than in the conduct of a business) by individual investors can be classified into four major categories: investment, home mortgage, education loan and consumer. Whether an interest payment is deductible or not will depend upon its classification. Generally, deductible interest expense can only be taken as an itemized deduction, and may be subject to limitations. Investment interest. This is the interest you pay on loans, including your margin account, used to finance taxable investments. In general, investment interest is deductible if used to purchase taxable investments, and then only to the extent of your net investment income. Any investment interest that is not currently deductible can be carried forward indefinitely. In any case, no deduction is allowed for interest paid on indebtedness incurred to purchase or carry tax-exempt securities. Deductions for investment expenses are not subject to either the 2% floor for miscellaneous itemized deductions or the phase-out for high-income taxpayers. Keep in mind that the IRS has sophisticated tracing rules in instances where taxpayers hold tax-exempt securities. Net investment income is your investment income minus your investment expenses. Investment income is defined as the sum of interest, dividends, royalties and net short-term capital gains, but excludes net long-term capital gains. You can elect to include as much of your net long-term capital gains in investment income as you choose if you also reduce the amount of net long-term capital gains eligible for the capital gains rate by the same amount. Investment expenses are those that are directly related to the production of investment income, such as those incurred for investment advice. Although excess investment interest expense may be carried forward, realizing short-term capital gains to offset excess investment interest effectively creates 24 a current tax-free source of income. (See pages 2-9 for more information on capital gains.) Home mortgage interest. The deduction for home mortgage interest depends on whether it qualifies as acquisition indebtedness or home equity indebtedness. Acquisition indebtedness is debt incurred in acquiring, constructing or substantially improving a principal or second residence. The loan must be secured by the residence. Mortgage interest is deductible on acquisition indebtedness of up to $1 million (one-half-million dollars for married taxpayers filing separately). Home equity indebtedness is debt secured by your principal or second residence and does not exceed the fair market value of the residence minus the acquisition indebtedness. Mortgage interest is deductible on home equity indebtedness of up to $100,000. Education loan interest is debt incurred on any qualified higher education loan. Eligible students may deduct interest paid on qualified higher education loans. The maximum amount of deductible interest is $2,500. Phase-out begins for modified adjusted gross income levels for 2002 of $50,000 for singles and $100,000 for married filing jointly. The deduction for interest on qualified education loans is an above-the-line deduction that is allowed whether or not you itemize your other deductions. Consumer interest is defined as any interest that is not mortgage, investment, education, trade or business related. It includes interest on loans to purchase consumer goods and interest on credit-card balances. Consumer interest is not deductible. Taxpayers are required to trace the use of proceeds on non-mortgage debt to determine its deductibility. You should develop a tax-wise borrowing strategy, focusing on proper planning and record-keeping. 25