Declare 401(k) freedom from the tax man

NEW YORK (Money) -- Question: My understanding is that due to the tax-deferred nature of retirement accounts, I ought to steer risky investments like international funds and individual stocks into my IRA and 401(k), while keeping mainstays like bonds and large-company stocks in taxable accounts. Is this a good policy? - Gary Banks, Santa Fe, New Mexico

Answer: You're familiar with asset allocation, right? It's the process of spreading your money among different types of stocks and bonds so you benefit from exposure to a variety of different asset classes.

Well, the strategy you're asking about is a variation on that concept that goes by the name "asset location." As in asset allocation, you're spreading your money around, except instead of diversifying by asset class, you're divvying up your investments between taxable and tax-advantaged accounts to get the most favorable tax treatment.

The idea is that by doing this you can increase the amount of money after taxes that you end up with in retirement. Indeed, a 2004 paper on asset location concluded that by putting investments in the wrong accounts some investors may be giving up 15 percent or more in potential retirement wealth.

So how do you practice asset location? The basic principle is fairly simple. To the extent possible, you want to devote investments that generate regular income or frequent capital gains to tax-advantaged accounts like 401(k)s or IRAs where they won't be immediately taxed.

That way all of the gain can compound, increasing your eventual after-tax return. Investments that throw off fewer regular gains - or gains that are taxed at more favorable rates - can go into taxable accounts since the tax hit on these investments is less severe.

As a practical matter, this means that bonds, whose interest payments are taxed at ordinary income rates as high as 35 percent, generally belong in tax-advantaged accounts. If you own stock funds that trade a lot and generate lots of realized short-term capital gains - which are also taxed at ordinary income rates - they should also typically go into tax-advantaged accounts (although, frankly, I'm wary of most funds that do rapid-fire trading).

Investments like index funds, tax-managed funds and tax-efficient stock funds that deliver most of their gains in share-price appreciation, conversely, should go into taxable accounts. (Ditto for individual stocks that pay no dividends.)

The reason is that these investments tend to throw off little in the way of regular realized capital gains. Most of their returns come in the form of a rising share price, which means you postpone recognizing a gain (and paying taxes on it) until you sell. And if you hold the shares longer than a year, you'll also be taxed at the more favorable capital gains tax rate, which maxes out at 15 percent.

Stocks that pay "qualified" dividends that get capital gains tax treatment, as well as mutual funds that hold such stocks, should also be held to the extent possible in taxable accounts. The reason is that the dividends these investments generate are taxed no higher than 15 percent in taxable accounts.

If you hold them in a tax-deferred account like a 401(k) or traditional deductible IRA, those dividends would be taxed at ordinary income rates that could be as high as 35 percent, since all gains withdrawn from 401(k)s and traditional IRAs are taxed as ordinary income.

Keep in mind, however, that practicing asset location does not mean that you invest only in bonds in tax-advantaged accounts or that you can put only index funds and other tax-efficient investments in taxable accounts.

For example, if you do virtually all your investing through your 401(k) plan, it would make no sense to own only bonds in your account. As tax-efficient as that might be, you would be limiting the growth of your nest egg by excluding stocks, which deliver higher long-term returns.

Similarly, if you do virtually all of your investing in taxable accounts, you wouldn't want to totally exclude bonds from your portfolio, as you would be giving up an important hedge against risk. So what's the right way to go about asset location? You want to arrange things so that your asset allocation and asset location strategies work in sync.

To do this, start by thinking of all your retirement assets as one big enchilada. Then decide on your asset allocation - that is, figure out how much of that enchilada should go into stocks and how much into bonds. (For guidelines on how to create the mix that's appropriate for your investing time horizon and risk level, click here.)

Once you know how your retirement savings should be allocated by asset class, you can then start looking at location. For example, if you've decided that 80 percent of your total retirement savings should be in stocks and 20 percent in bonds, then ideally you would load up your 401(k) or IRA with bonds until it hit that 20 percent target. Only after that would you begin adding stocks to your 401(k) or IRA.

So let's say you have $100,000 in retirement savings - $50,000 in a 401(k) and $50,000 in taxable accounts - and you have an 80-20 stocks-bonds target mix. You would put $20,000 in bonds in your 401(k). That would get you to your 20 percent bond allocation.

The remaining $80,000 would be invested in stocks, with $30,000 going into your 401(k) and $50,000 in stocks going into taxable accounts. This would mean 40 percent ($20,000 of $50,000) of your 401(k) was invested in bonds and 60 percent in stocks, while 100 percent of your taxable account was in stocks.

Overall, however, your $100,000 would reflect your 80-20 target mix with $20,000 in bonds and $80,000 in stocks. But by allocating the bonds to your 401(k) rather than holding bonds in both your 401(k) and taxable accounts (or all the bonds in your taxable accounts), you shelter more of the bonds' income from taxes and increase your after-tax return (and wealth) over the long-term.

If you do all or nearly all of your investing in 401(k)s and similar accounts (which I suspect is true for many people), this isn't really much of an issue. You just divvy up your money to reflect your asset allocation. (The same goes, of course, if you do all your investing in taxable accounts.)

If you have both types of accounts and you're heavy in bonds in your taxable accounts, you might consider selling some of them and re-investing the proceeds in index funds or other tax-efficient stock funds.

If necessary, you can then increase your bond holdings in your 401(k) or IRA either by selling some stock funds within those accounts and buying bonds (which you can do without triggering taxes in such accounts) or by plowing new contributions into bonds.

While I think asset location is a worthwhile pursuit, I don't think you need to be a fanatic about it. I still say the most important things you must do to assure a successful retirement are save on a regular basis and get your asset allocation right. But if you do those things and improve your asset location as well, you can look forward to an even more comfortable retirement.