Question: I recently became a father (first time) and was wondering what type of investments I could make in my daughter's name that would help reduce my taxable income. If I do make such an investment, am I later allowed to withdraw any of the accumulated funds without being taxed ?

Answer: The possibilities for investment of funds in your daughter's name are virtually unlimited. You can open a passbook account or take a certificate of deposit at a savings institution; buy Series E or H bonds or other government securities; or buy bonds or stocks, or shares in any of a large variety of mutual funds.

The money you invest for the child is after-tax dollars; that is, you can't protect the original source of the funds (your salary, for instance) from taxation.

But the income earned by the money invested in the child's name is income to the child, and will be exempt from tax unless and until the child has enough income to make her subject to tax. Even then, she will certainly be taxed at a lower rate than you would pay on the same income.

(Since the oncome is protected from tax anyway, obviously it wouldn't make good sense to invest the funds in municipal bonds or other tax-sheltered investment.)

The investment in your daughter's name is in reality a gift to her. You can give her up to $3,000 in each calendar year ($6,000 if your wife concurs in the gift) without incurring liability for gift tax. Any amount above that would be charged against your lifetime combined gift/estate tax exclusion.

Because it is a fift with tax-savings implications, the question of later withdrawal is not so clear-cut. The rule is that you are permitted to withdraw income or principal (or both) only if you expend the funds withdrawn for the benefit of the child.

Normally the government will not question your right, as parent, to determine what is in the best interests of your minor child. (The child, of course, can -- and three have been cases of children suing their parents for misappropriation of the child's funds.)

It is clear under the law, however, that you may not retrieve the funds, once given, to use for your own purposes or to pay for those things which you, as parent, are required to provide the child -- food, shelter, etc. Q: Last year I invested some money in a tax-free mutual fund. The annual earnings statement shows some taxable income. How come ?

A: The mutual fund invests the money of its shareholders in tax-free municipal bonds. The interest income from these bonds retains its tax-free nature when passed on to the investors.

But there is a time lag between receipt of cash from shareholders and investment of that cash in bonds. And in a falling bond market the fund managers may retain the cash longer than normal, waiting for a chance at a higher rate of return.

That retained cash is not kept in a desk drawer in the office. It is usually placed in an interest-bearing account until needed. The interest earned on that account is not tax-free; so when it is pair to the shareholders it must be segregated from the tax-free income and identified as taxable interest.

In addition, the fund managers generally make portfolio transactions during the year. That is, they buy and sell bonds for the portfolio depending on their view of the market conditions and the characteristics of specific holdings.

Any capital gain realized on these portfolio transactions (and passed on to the shareholders) is taxable even though it resulted from the sale of tax-free securities.

A column on family finances and taxes will appear in The Washington Post Business & Finance section on alternate Fridays. The author, E.M. Abramson, is a family financial counselor and tax adviser. Questions of general interest on tax matters, insurance, investments, estate planning and other aspects of family finances will be answered in the column. Advice cannot be given on an individual basis. Address all questions to E.M. Abramson, The Washington Post, Business & Finance News, 1150 15th St. NW, Washington D.C., 20071.