IN THE RUN-UP

to the general election in November the issue of investment taxes has been overshadowed by the ailing economy and the war in Iraq. But with rates scheduled to reset to higher levels not long after the new president takes office, voters are starting to give the candidates' positions closer scrutiny.

During last week's Democratic debate in Pennsylvania, which holds its key primary on Tuesday, both presidential hopefuls were grilled about their plans for taxing investment income, namely capital gains and dividends. Their answers weren't encouraging for holders of stocks and mutual funds.

The tax rate on capital gains, from the sale of stock or other assets such as a house, is scheduled to rise to 20% by the end of 2010 from its current 15%. The tax on dividends that companies pay shareholders will increase from 15% to an individual's marginal tax rate. The top marginal rate now is 35% and slated to rise to 39.6% after 2010. These hikes will happen unless the next president and Congress reach agreement to keep the lower 15% rates passed in 2003.

Sen. Barack Obama (D-Ill.) said during the Pennsylvania debate that he will consider raising the capital gains tax to as high as 28%. Sen. Hillary Clinton (D- N.Y.) says she could raise it to a maximum of 20%, "if I raised it at all." Republican frontrunner Sen. John McCain (R-Ariz.) has said he'd keep the cap-gains and dividend tax rates at 15%, but he'll have to convince Congress first.

"Part of the reason the stock market has been weak is electronic trading sites are predicting a Democrat will win the presidency, and the market is starting to discount the higher tax rates," says Horacio Valeiras, managing director and chief investment officer of Nicholas-Applegate Capital Management.

"Our view is taxes are going up," Valeiras says. "We're positioned to be more defensive and buying stocks we think will deliver returns in a slower economic environment."

Capital gains and dividend taxes especially affect investors in mutual funds, which is how most Americans invest in stocks. People who own stocks directly, not within mutual funds, only pay the cap gains tax if they sell shares, giving them more control of when they pay Uncle Sam. In mutual funds, taxes are paid annually on gains even if the fund is held long term. For people only investing in stocks through tax-advantaged retirement plans such as 401(k)s, the cap-gains and dividend taxes don't have such an immediate impact because taxes generally are paid after the money is withdrawn.

Of the nearly 90 million Americans who own mutual funds, just over one-third hold them in long-term taxable accounts, according to the Investment Company Institute, which is the national association of investment companies and has long advocated for permanently lower tax rates on investment income. "Congress is clearly looking at ways to raise revenue right now," says ICI spokesman Edward Giltenan.

The political debate over investment taxes centers on whether they add to the budget deficit while only benefiting a wealthy few, or if they're an economic tool that can spur growth. Obama, who has a slight edge in the Democratic race, said during Pennsylvania's debate last week that he'd consider raising cap-gains taxes "for purposes of fairness," because wealthy investors who make most of their money off stocks shouldn't get a lower tax rate than people who earn most of their income from wages. McCain, in contrast, says low taxes on cap gains and dividends "channel investment dollars to innovative, high-value uses."

Ryan Ellis, executive director of the American Shareholders Association, a political advocacy group pushing for lower investment taxes, says all investors not just those with taxable accounts should be aware of the impact of the candidates' policies. "Most Americans own stocks in 401(k)s and IRAs, but even if they're not directly paying these taxes in their retirement accounts raising the cap-gains rate has a high correlative effect on the stock market's performance," says Ellis, who says he only has tax-advantaged accounts.

"If you own a share worth $100 and you're anticipating a higher capital-gains rate, there's going to be a discount because your future profit isn't as high, and therefore the share is worth less because people aren't willing to pay as much," Ellis says. "If shareholders are aware of the difference between the Democratic nominee and McCain, there's not a starker contrast than on the tax issue. Maybe the Iraq war is bigger, but that's about it."

To be sure, cuts to the capital-gains tax have coincided with higher receipts from the tax to Uncle Sam, according to data from the Treasury Department. Cuts to the dividend tax, meanwhile, have coincided with an increase in companies that pay dividends, according to the National Bureau of Economic Research.

For investors more worried about their bottom line than the politics of it all, there are some steps to take to ensure you're at least being tax-efficient. The most basic, says Douglas Jackman, executive vice president and a portfolio manager of the Thomas White International Fund, is to put funds with high share turnover which will have more short-term gains in tax-sheltered plans such as a 401(k) or IRA. The same is true for funds that pay a lot of dividends. "It's hard to plan for uncertainty, but whatever the tax rates are retail investors should be cognizant of it and think about allocation," Jackman says.

Put municipal-bond funds, tax-managed stock funds and variable annuities in taxable accounts, says Duncan Richardson, executive vice president and chief equity investment officer of Eaton Vance Management, which runs several tax-managed funds. If there's any doubt that investment taxes can add up, he points to research by Tom Roseen, of mutual-fund tracker Lipper, which estimates that mutual fund investors, in taxable accounts, paid at least $22 billion in taxes to Uncle Sam last year because of cap-gains distributions, up more than 50% over 2006.

In this election season, Richardson, adds, "It's not unpatriotic to do what the tax laws require as your fair share."