Q.   Like many others, I am concerned about my 401k plan choices. I had about $35,000 as of the first of the year but it is losing ground as we speak. I contribute $2,000 a year, as my company will only match fifty cents on the dollar up to a maximum of $1,000.   My question to you is where should I put my money right now? Currently, I have 40 percent in Fidelity Magellan, 40 percent in American Century Ultra, and 20 percent in Fidelity Puritan.

My other choices are: American Century Short Term Government Income, Fidelity Asset Manager, American Century Growth Fund, and American Century International Growth Fund. What would you do?

---R.P., San Antonio, TX

  

A.   While you are "capturing the match" from your employer, which is good, the ultimate guide to how much you contribute should be how much you NEED to save, not how much your employer contributes.   Your employer won't match your contributions over $2,000 a year but they will still be tax-deductible. This means you'll have a lower income tax bill.

You can lower the volatility of your account by eliminating the skittish American Century Ultra fund. A 40/60 mix of Magellan and Puritan would give you a 40 percent holding in "large blend" stocks (via Magellan), a 36 percent holding in large value stocks (via Puritan), and a 24 percent holding in fixed income (via Puritan). Over the last 10 years Puritan has been in the top 5 percent of balanced funds and provided a compound return of 13.46 percent annually at half the risk of the average domestic equity fund--- even though the average equity fund provided about the same return, 13.61 percent.

  

Q. I have been in a mutual fund for over 10 years. I divided my investment, with one half going into a mid-cap fund and another into a growth stock fund. I purchased this fund with after-tax money. My idea was that I would pay some gains each year as they were realized and those reduce my tax situation at retirement. This fund is to be used as a bridge to my 401k when I retire.

Normally, I paid little in capital gains. Until this year. When filing my taxes for 2,000 I discovered that this fund company had declared a very large dividend payout ($32,169.23) for both funds. The net result is that while my fund actually lost money this year, I am faced with an extraordinary capital gains tax (20 percent) on money that I actually have never received.

I have asked the mutual fund company to explain this transaction but for some reason it just isn't making sense. I plan to retire in four years. Should I place this money elsewhere?

---D.R., by e-mail

  

A. If you have been holding those funds for 10 years, chances are you were not seeing all the capital gains and are now realizing all of them as the fund struggles to meet redemptions and/or raise cash. In effect, your tax bill was saved for a rainy day, the opposite of what we would like to see.

One of the most difficult things to understand about mutual funds is that fund distributions only reflect taxable events. They don't reflect the ups and downs in the daily value of your investment.

Suppose you purchased a fund for $10 a share last year. Your potential tax obligation would depend on whether the fund had unrealized capital gains or not. If the fund had $5 a share in unrealized capital gains you would have bought a tax liability of about $1 a share (figuring 20 percent in capital gains taxes). Note that this liability has absolutely no relation to how the fund performs for you. It is just a tax liability that will eventually come your way.

The liability could be realized at any time by the fund manager, regardless of what happens to the net asset value per share of the fund. In the worst of all possible worlds (much like the last 12 months) the net asset value of the fund could decline to $8 and the fund manager could be forced to realize all capital gains. As a result, you could receive a $5 capital gain distribution on your shares.

Similarly, the fund could have increased in value to $12 a share and the fund manager could hold all his aces, realizing no capital gains. So at the end of the year you would have $12 a share and $7 in unrealized capital gains that could come home at any time.

The key is unrealized capital gains when you buy.

Market ups and downs can also create tax saving opportunities. There have been periods when virtually all bond funds had net loss carry forwards. Similarly, there are mutual funds that have substantial unrealized capital losses. According to the Morningstar mutual fund database, 2987 domestic equity funds now have no unrealized capital gains. This means you could buy the shares without "buying a tax liability."