3 rules of investing: Location, location, location

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NEW YORK (Money) -- Question: Having just read several of your articles on retirement planning, I have these questions regarding tax deferred and taxable accounts during retirement:

I have chosen an asset allocation of 50% stocks and 50 % bonds. But I have two retirement accounts (a taxable and a tax-deferred), and I'm not sure how to divide them up. Should I keep both of my accounts split down the middle between stocks and bonds? Or keep the stocks in one account and bonds in the other?

The Mole's Answer: You have done the right thing by first picking an asset allocation that is right for you with the 50/50 split between stocks and bonds. The question you pose runs a close second in importance; Where should you locate those assets between your taxable accounts and your tax-deferred accounts, such as an IRA or 401(k)?

We finance types talk about asset allocation ad-nauseam. But locating our assets where they are most tax-efficient can be every bit as important as asset allocation. And, as a matter of fact, it can result in more wealth, regardless of what the market is up to, or down to.

In reviewing the accounts of new clients, I typically see that their previous advisers tended to put their stocks in their tax-deferred accounts and bonds in their taxable accounts.

The conventional logic goes something like this: retirement accounts are long-term and should be invested in equities, while you are likely to spend out of your taxable accounts earlier so they should contain less-risky investments like bonds.

Since we can't really tap into that retirement money for many years, we seem to think of our taxable money as more "real," so we want to use more caution in investing it.

But when clients come to me with a portfolio like this, I tactfully clue them in to the fact that they have it completely backwards.

Stock index funds are very tax-efficient, while the interest from fixed income, such as a bond index fund, is taxed immediately and at the highest ordinary income rates. So placing fixed income in taxable accounts is a mistake, because it fails to:

• Utilize the lower tax rates on qualified stock dividends and long-term capital gains.
• Defer the taxes from capital gains. Broad index funds have nearly no turnover, which allows you to defer the gains for decades.

Let's take a simple example of someone with a $200,000 investment portfolio who wants 50% in fixed income and 50% in stock. Now let's assume that half of the money is in a taxable account and half is in an IRA. We'll also assume the equities will earn 8.5% annually and the fixed income earns 5%. Finally, let's say he is in the 28% tax bracket.

If this investor does as most people do and places the fixed income in his taxable account and equities in his IRA then, after twenty years, he will have amassed $571,000, after paying all taxes. But if he merely reverses the location of those assets, he would have accumulated $629,000 or $58,000 more!

This tax engineering increases return without increasing risk one iota. What's going on here is that the IRA account is going to be taxed at ordinary income whether it's in stocks, bonds or anything else. Thus you want both your fastest growing and most tax-efficient investments outside of your IRA account. Stock index funds fit this bill.

You seem concerned about an emergency cash reserve. So let's do a worst case scenario. Say you need to raise some $20,000 cash by selling stock in your taxable account after only one year.

Selling the stock in your taxable account leaves you with two problems to solve. First, you may have to pay taxes on gains. This isn't good, but it's still better than if you had held your bonds in the taxable account and paid the highest ordinary income tax rates on the interest. At least you will be paying a lower tax long-term capital gains tax rate.

The second problem is that you are doing some unintentional market timing. What if you sold the stock funds at the bottom of the market? This problem is easily solved by simultaneously selling some of your bond funds in the IRA account to buy the appropriate amount of stock funds. Since it's in an IRA, there are no tax implications.

First select an asset allocation that's right for you. Then locate your assets where they are most tax-efficient. For your taxable accounts, I suggest stock index funds. For your tax-deferred accounts, consider CDs, taxable bonds, REITs and other investments taxed at the highest rates.

There's an old saying in real estate, that to be successful, it pretty much comes down to location, location, location. The same goes for investing, since minimizing taxes is also an important component to building wealth.

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