An Overlooked Element of Asset Allocation: Location, Location, Location

(MoneyWatch)  As we all know, asset allocation is critical for balancing risks and returns in your portfolio. But did you know that managing the location of the assets is nearly as important? Doing it right is guaranteed to result in greater growth of your portfolio, no matter what crazy ride the market takes us on.

The kink in the conventional wisdom
The conventional wisdom holds that because 401(k), IRAs and other tax-deferred accounts are long-term arrangements, they're best suited for equities. Conversely, taxable accounts are considered "real money," and should therefore hold more conservative investments such as bonds or CDs.

The kink in this logic is that equities, especially low turnover mutual funds, can be very tax-efficient, while fixed-income securities like bonds and CDs are taxed immediately and at the highest ordinary income rates. So keeping bonds and similar assets in a taxable accounts fails to:

• Take advantage of the lower tax rates on qualified stock dividends and long-term capital gains.
• Defer capital-gains taxes on stock sales, allowing you to earn more on the money Uncle Sam lets you hold for a while. Yes, stocks will go up again.

Tax savings for the taking
Let's take a simple example of someone with a $200,000 investment portfolio who wants half in bonds and CDs and half in stock. Now let's assume that half of it is in a taxable account and half is in an IRA. We'll also assume the equities yield an eight percent return and his fixed income earns six percent. Finally, let's say he is in the 28 percent tax bracket.

Now, if this investor does what most people do and puts the bonds and CDs in his taxable account and equities in his IRA, then after twenty years he's amassed $568,000 after taxes. But if he reverses the location of those assets, he'll have $609,000, or $51,000 more! Not too shabby considering it was the same amount of risk.

What if market returns vary or tax rates go up? Surprisingly, it doesn't matter. Under any scenario I can think of, you're always better off putting tax-efficient investments in your taxable accounts, and tax-inefficient investments in your tax-deferred accounts.

What investments to put where
So, where do you go from here? First, determine how much risk you want to take and build your asset allocation according to that amount of risk. Then determine where to put the assets. For your taxable accounts, I suggest low-turnover equity mutual funds and enough cash for emergencies. For your tax-deferred accounts, consider CDs, taxable bonds, REITs, and other investments taxed at the highest rates.

Take my advice and do a little tax re-engineering. By putting the right assets in the right locations, you'll guarantee a higher return. It's easy once you get there. Just be sure to watch out for tax landmines, such as the alternative minimum tax. In fact, if you even suspect that the AMT might raise it's ugly head, seek professional help immediately.

It's like that old real-estate saying -- success basically comes down to three things: location, location and location.

Here's a quick guide:

Assets to place in tax-deferred accounts:

• Bonds
• CDs
• REITs
• Stocks or stock mutual funds that trade stocks actively

Assets to put in taxable accounts:

• Low-turnover equity mutual funds
• Individual stocks held for long periods of time