Taxes Have a Role in Asset Allocation

Most of us pay heed to the basics of asset allocation -- placing your investments in a variety of different assets, such as large company stocks, small company stocks, bonds and real estate, to maximize returns and minimize risk.

But chances are you haven't given much thought to the location of your investments. Namely, whether they sit in your tax-sheltered 401(k) and IRA, or reside in taxable accounts with a brokerage house or mutual fund.

Three professors of finance have given the issue serious consideration. They've concluded that putting bonds in tax-sheltered retirement accounts and stocks in taxable accounts can over time boost your portfolio by as much as 15% to 20%.

"You're not taking on more risk, you're just putting things in the right place," says co-author Robert Dammon, professor of financial economics at the Tepper School of Business at Carnegie Mellon University.

The study, co-authored by Chester Spatt, Mellon Bank professor of finance and director of the Center for Financial Markets at Tepper, and Harold Zhang, associate professor of finance at Kenan-Flagler Business School at the University of North Carolina, appeared in a recent issue of the Journal of Finance.

Here's their rationale. Using asset allocation, investors should have some bonds in their portfolio. Many investment advisers recommend that the proportion of bonds increase as investors age and approach retirement.

Bonds pay interest, which is taxed at ordinary income rates that range from 25% to 35% for middle- to high-income earners. By comparison, stocks don't generate taxes until they are sold, producing capital gains, currently at 15% for the top four tax brackets and 5% for the lowest two brackets. Some stocks pay dividends, and these are also taxed at the 15% and 5% rates.

"The tax rate on equities is much lower than the tax rate on bonds," says Dammon. So, as long as you need bonds in your portfolio, they should be in your tax-deferred accounts, where their interest payments won't generate an annual tax bill.