Where to hold your investments

You need only seven investments for a complete portfolio, but your job isn't over once you've picked them. Then comes asset location - the art of holding investments in accounts where the IRS can do the least damage to them.

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By Michael Sivy, Carla Fried, Carolyn Bigda and George Mannes, Money Magazine

What to hold in your 401(k)

(Money Magazine) -- You've read it in these pages, oh, at least a thousand times: The first dollars you save should be plowed into your tax-deferred 401(k). This is especially true if your employer matches your savings, which means the boss pays you for doing what you need to do anyway - save. But which of your funds belongs in your 401(k)? It depends where you are as an investor.

Just getting started? Then you're probably doing most or all of your investing through your 401(k). In that case, take the easy way: Build your seven-fund plan entirely within your employer-sponsored account. If your 401(k) plan doesn't offer all of the seven funds on our list (many plans have limited offerings), don't worry. The vast majority offer some blue-chip U.S. stock, foreign stock and high-quality bond funds, and many also offer small-stock and value options.

Further along? Once you start to acquire investments outside of your retirement plan too - in a regular brokerage account, for example - you need to pay closer attention. Inside your 401(k), priority seating goes to the funds subject to the highest taxes - namely, your taxable bond funds; they throw off interest that, outside a retirement plan, would be taxed as ordinary income.

Outside your 401(k), consider funds least likely to interest the IRS: those that generate little taxable income or whose distributions receive beneficial tax treatment. Generally speaking, this means your stock funds.

This is certainly true of the equity portfolios among our top picks. They rarely generate taxable income. But when they do, much of it is in the form of either long-term capital gains or qualified dividend income. Both are taxed at a comparatively gentle maximum rate of 15%.

What to hold in an IRA

After a 401(k) with a company match, the next friendliest place for your savings is an IRA. The Roth version is particularly intriguing if you qualify (for you to contribute, your income must be below certain limits).

In this type of IRA, you get no deduction for what you put in; however, money inside the Roth is allowed to grow untaxed and, unlike money in a regular IRA, also escapes taxation when you withdraw it. (In a regular IRA or 401(k), you generally owe taxes on the cash you pull out.) The Roth is appealing if you think tax rates will rise in the future - not an unreasonable bet.

Which funds belong in an IRA? As with a 401(k), your IRA should give priority to the bonds in your portfolio, and for the same reason: Outside a retirement account they'd be taxed much harder than your stock funds. It's especially important to shelter your inflation-adjusted bond funds, or TIPS funds, from the tax man.

The principal value of these bonds rises to keep pace with inflation. Although you don't get the full benefit of these inflation adjustments until the bond matures or is sold, the IRS regards them as regular interest income and taxes you each year. That is, unless your fund is protected in an IRA.

A 401(k), of course, would offer comparable tax shelter, but as of now fewer than one in eight offer such a fund. So if you're going to make a TIPS fund part of your simple portfolio - and you should - you'll want to make sure you buy it in your IRA.

What to own in your brokerage account

Since you can save only so much each year in 401(k)s and IRAs, you probably already own some funds in a regular taxable account at your brokerage or mutual fund family. There's no hiding from Uncle Sam in these funds.

Still, there are some advantages: If a fund drops below your purchase price, you can "harvest" the loss by selling shares and, at tax time, netting the loss against an otherwise taxable gain. You can't do that in an IRA or a 401(k). Plus, long-term gains and qualified dividends enjoy the reduced 15% tax rate; in a traditional 401(k) or IRA, every dollar of income - gains and dividends included - is subject to your full ordinary income tax rate when you withdraw it.

Which funds belong here? Your taxable accounts should be the home for the stock fund portion of your simple portfolio. Don't hold any bond funds here unless your plan requires you to have more money in bonds than you can shelter in your IRAs or 401(k)s. To top of page

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