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Dear Dagen: Bush's Tax Cut and Your Portfolio

An issue I am not seeing much analysis of is what investments are appropriate for an IRA or other tax-advantaged account now that long-term capital gains and dividends are taxed more favorably. Intuitively, it seems we should put bonds or real estate investment trusts into tax-deferred accounts and put anything with long-term gains and dividends into taxable accounts. Alternatively, and more dangerously, we could use our IRAs as short-term trading accounts. I'd appreciate your thoughts. -- Steve C.

Taxes shouldn't be the first thing you think about when you invest. But they should come in a close second. First decide what you want to own; then you can think about where to put those investments.

"You should be thinking about how you arrange different instruments between tax-deferred and taxable accounts," says Fran Kinniry, a principal in investment counseling and research at Vanguard. "Asset location is as important as asset allocation."

This exercise becomes even more worthwhile following President Bush's reduction in the taxes on dividends and capital gains. Stock dividends and long-term capital gains will now be taxed at an ultralow 15% rate, while the interest from bonds and short-term capital gains will be treated like ordinary income, meaning it can be taxed at a rate as high as 35%.

Broad Strokes

Broadly speaking, you should keep an already tax-efficient investment, like a broad stock market index fund, in a taxable account. Meanwhile, assets like bonds and real estate investment trusts that produce income taxed at much higher rates should be housed in a tax-deferred account, like an IRA or 401(k). You ultimately will pay that income tax when money comes out of a retirement plan. But you get to postpone that day, and in the meantime that extra cash can work in your favor through compounding.

Bonds and REITs go in the retirement plan. Index funds and dividend-paying stocks stay out.

That's the supersimplistic way of looking at organizing your investments. You can get a lot more complicated if you want.

Fine-Tuning

You can start by identifying any securities or mutual funds that produce interest income or short-term capital gains. A fund that's run by a manager who trades constantly and regularly distributes short-term gains should go in a tax-deferred account.

Ditto if you like to trade. Constantly buying and selling stocks or funds is not a surefire way to make money, especially when any short-term gains that you do realize will face much higher income tax rates. But if you have to trade, then try and do it in your IRA. (Most 401(k) plans won't let you trade stocks.)

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