Gerber and Co., CPAs and Financial Advisors

Taking care with asset placement can result in big tax savings.

I'll confess: When it comes to matters of money and investing, there are a handful of topics that make my head hurt. One of them is "asset location"--essentially, the placement of investments in taxable or tax-sheltered accounts.

Why is asset location such a sticky wicket? For one thing, the tax treatment of investments

changes frequently, so what may be an optimal asset placement today may not be a few years

from now. Dividends provide a great case in point. Prior to 2003, income from stock dividends

was taxed at the ordinary income tax rate, so you'd generally want to hold income-rich stocks

in your tax-sheltered accounts.

But when dividends began to be taxed at the lower, capital-gains tax rate, they were no longer

verboten for taxable accounts. As the currently low dividend-tax rates are set to expire at the end

of this year, dividend-tax treatment is again up for grabs, so I'd be hard-pressed to recommend

that you hold dividend payers in your taxable accounts until there's some clarity on the issue.

In addition to tax treatment confusion, practical considerations sometimes completely contradict advice that makes good tax sense. Most of us naturally use our retirement accounts (401(k)s and other company-retirement plans and IRAs) as a storehouse for our longest-term savings, so it's only logical that we'd be inclined to invest in long-term assets (namely, stocks) there.

Meanwhile, from a practical standpoint it's logical to want to hold more safe, stable, and liquid assets (namely, bonds and cash) in accounts that we can readily tap without strictures or penalties--our taxable accounts. Yet as much logical sense as those asset-placement arrangements might seem to make, they precisely contradict what a tax advisor would tell you to do. Because income from bonds and cash is taxed at your ordinary income tax rate, that's a powerful argument for holding bonds in your tax-sheltered accounts while keeping at least some stocks in your taxable account.

So how should you navigate this confusing landscape? There are no one-size-fits-all solutions, and it's worth revisiting your asset-location framework every few years, to make sure your plan syncs up with the current tax rules. But here are some general guidelines.

Hold in Your Tax-Sheltered Accounts: High-Returning Assets with High Tax Costs
Because you don't have to pay taxes from year to year on income or capital gains you earn in tax-sheltered accounts like IRAs and 401(k)s, these are good receptacles for higher-returning investments that also have heavy tax consequences. The best example would be junk bonds, junk-bond funds, and multisector-bond funds, all of which kick off a high percentage of taxable income. And while it's a stretch to call high-quality bonds and bond funds "high-returning" right now, they're also a better fit for tax-sheltered accounts than for taxable because their payouts are taxed at an investor's ordinary income tax rate.

So generally speaking, to the extent that you hold bonds, you're better off doing so within the confines of a tax-sheltered account. If you need to hold bonds in your taxable accounts, use the tax-equivalent yield function of Morningstar's Bond Calculator to determine whether a municipal bond or bond fund might offer you a better aftertax yield than a taxable bond investment. (Income from munis is free of federal and, in some cases, state income taxes.)

By contrast, stocks and stock funds are generally a better bet for taxable accounts, for reasons I'll detail in a minute. That said, not all stocks belong in the taxable bin. Although they enjoy relatively low tax treatment currently, dividend-paying stocks are arguably a better fit for taxable rather than tax-sheltered accounts.

As I noted earlier, the tax treatment of dividend income is set to expire after this year; unless Congress takes action, dividends will again be taxed as ordinary income beginning in 2011. Also, dividend income, like bond income, isn't discretionary. Whereas stock investors can delay the receipt of capital gains simply by hanging on to the stock, investors in dividend-paying stocks don't have that kind of control. That makes dividend payers, regardless of tax treatment, less attractive than nondividend payers from a tax standpoint.

Your tax-sheltered accounts are also the right spot for REITs, whose payouts are generally considered nonqualified and taxed at ordinary income tax rates. Preferred stock, too, is on the bubble, depending on the type of preferred you're dealing with, and therefore is apt to be a better fit within the confines of a tax-sheltered account. Traditional preferreds generally qualify for dividend-tax treatment, whereas income from trust preferreds is taxed at an investor's ordinary income tax rate. Dividends from some foreign stocks and funds may also be classed as nonqualified, meaning they will be taxed as income.

Finally, to the extent that you hold mutual funds that churn through their portfolios frequently, you're better off doing so within your company-retirement plan or IRA. Such funds tend to generate a lot of short-term capital gains, which are also taxed as ordinary income.

Hold in Your Taxable Accounts: Higher-Returning Assets With Low Tax Costs
The above exceptions notwithstanding, there are compelling reasons to hold stocks in your taxable rather than tax-sheltered accounts.

As I noted earlier, long-term capital gains, which is what you have when you sell a stock that you've held for at least a year, are taxed at a much lower rate than is bond income--currently 0% for investors in the 10% and 15% tax brackets, and 15% for investors in the 25% tax bracket and above. (Those favorable tax rates, like dividend tax rates, are set to expire at the end of 2010. But if they do, they'll revert back to the rates in place before 2003--20% for most investors.)

Another key reason to hold stock in your taxable accounts is that stock investors can also exert a higher level of control over the receipt of capital gains than bond investors--for example, by buying and holding individual stocks or by investing in exchange-traded funds, which have a built-in mechanism for limiting taxable capital-gains payouts. Tax-managed funds and traditional broad market stock-index funds also tend to do a good job of keeping the lid on distributing capital gains.

Hold in Either Account Type: Lower-Returning Assets with High Tax Costs
So the key rules of thumb are that stocks go in taxable accounts and bonds go in tax-sheltered wrappers. But what about lowly old cash? From a pure tax standpoint, holding the assets in a tax-sheltered account makes the most sense, as income from cash investments is taxable as ordinary income, just like bond income.

Here's a case, however, where practical considerations may override the tax argument. One of the key benefits of cash is easy access to your money when you need it, so it simply doesn't make sense to store cash for near-term income needs in tax-sheltered accounts, where you may face taxes and other penalties to pull it out prematurely. And because you're receiving a minuscule income stream from most cash investments these days (you may be holding them for stability as much as real income), the tax hit associated with holding cash in a taxable account is apt to be quite low for most investors.

The bottom line is that if you're holding cash for near-term income needs or as an emergency fund, it makes sense to hold it in a taxable account. If you're holding a sleeve of cash as a component of your retirement portfolio's long-term strategic asset-allocation plan, it's fine to hold it within the context of your tax-sheltered account.