A Nasty 401(k) Tax Surprise
If you hold most of your stocks in a 401(k) plan, you could be handing Uncle Sam more than his fair share
By Jason Zweig

(MONEY Magazine) – How often do you say "Whoops!" about your investing decisions? I've been kicking myself lately over a mistake that I'll bet you've made too. My 401(k), I've come to realize, is a big, fat tax mess.

What most investors seem to do (and what I did) is decide how much money they want to put in stocks, how much in bonds—and then divvy their money up along those lines in both their 401(k) and their regular taxable accounts. I've long kept roughly 80% of my money in stocks and 20% in bonds—in my taxable and retirement accounts alike. The typical 401(k), according to the Employee Benefit Research Institute and the Investment Company Institute, has 67% in stocks and 33% in bonds, cash and other income securities.

Now, if your 401(k) is the only place you invest, there's nothing wrong with favoring stocks there. But if you also invest outside your company's plan, then it turns out that you will be much better off favoring bonds in your 401(k) and stocks in your other, taxable accounts. Why? This division of your assets will cut your taxes to the bone, saving thousands or even tens of thousands of dollars. "You should view the tax code not just as a burden, but also as a tool that you can use to increase your overall rate of return," says New York financial planner Gary Schatsky.

While your 401(k) fights off taxes, it can't kill them entirely. Sure, the money you pay into it gets you a tax break today and is exempt from taxes until you retire. But once you start taking money out, it will typically be taxed as ordinary income—up to 35%.

In a regular taxable account, you pay as you go. Income from taxable bonds gets nicked for up to 35%, so it makes sense to hold those in the tax-deferred 401(k) instead. But with stocks, you pay a maximum of 15% in a taxable account when you realize a capital gain, and the same for most dividends. See the difference? "In a 401(k), you turn those long-term gains that would have been taxable at 15% into a 35% tax bill when you take them out," says Robert Gordon, president of Twenty-First Securities, a brokerage and investment firm. What's more, in taxable accounts you can take a deduction on losses.

Carnegie Mellon finance professor Robert Dammon points out another wrinkle: Say you buy a tax-managed index fund in your regular account and never sell it. You could pay almost no current income tax on it for the rest of your life. Put the same fund in your 401(k) and you'll have to start withdrawing from it—and pay that toll of up to 35%—after you retire.

GET IN THE RIGHT LANE I'll be the first to admit that this advice is counterintuitive. "Many people," says Berkeley finance professor Terrance Odean, "apparently think that the most speculative stock investments have the highest potential for the greatest gains and, therefore, the biggest tax bills, so they put them in their retirement account." Then there are people like me, who use one asset-allocation plan for everything just to keep things simple. But there is such a thing as being too simple.

Of course, none of this means that either 401(k)s or stocks are a bad idea. It does mean that you want your stocks to go where they will earn the highest return after you pay Uncle Sam his toll.

Start by putting all your money (taxable or retirement) into a single mental pie. Say you opt for a basic asset allocation of 60% stocks, 40% bonds. The best way to do that is to bulk up your 401(k) with bonds until they make up 40% of your total financial assets. Only after you reach that point should you add stocks to your 401(k). If, for instance, you have $50,000 in your 401(k) and $50,000 in taxable accounts, you'll need to put $40,000 in bonds to reach the 60-40 mix. If that all goes into the 401(k), you'll have 80% of that account in bonds. And 100% of your taxable account will be in stocks. This strategy should raise your after-tax return, unless tax laws change in totally unprecedented ways.

If you own taxable bonds or bond funds in a regular account, consider selling them—especially if you've held them for more than one year, entitling you to the maximum 15% tax rate on long-term capital gains. Then put the proceeds in a tax-efficient stock index fund and add bonds to your 401(k). Are you already stock-heavy in your 401(k)? No need to dump your stock funds in one fell swoop. By reallocating your new contributions, you can fix your mix gradually over time.

Finally, if you have no significant balance in taxable accounts, it's okay to mix stocks and bonds together in your 401(k) for now, points out Catherine Gordon of Vanguard Investment Counseling & Research. But down the road, if you add investments in a taxable account, put your stocks there and switch into bonds within your 401(k).

All too many investors live by what I call the "inverse law of attention." The less important something is to their long-term financial results, the more attention they pay to it. And the more important it is, the less care they give it. For every hour you've spent trying to guess which investments will earn a big return, you've probably spent less than a minute thinking about your investment taxes. And yet managing taxes wisely is the simplest way to raise your returns.

By the time you read this, I'll have started fixing my mix. Now it's your turn.