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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.

Once you begin taking distributions from your 401(k) or IRA account during retirement, your investments earnings -- whether from bond interest or stock capital gains -- will be taxed at your ordinary income tax rate. (The exception is the Roth IRA, whose earnings are tax free.)

However, many investors don't take this into consideration. One previous study has shown, for example, that 48% of investors who own bonds in taxable accounts also own equities in tax-deferred accounts. "People don't do the right thing," says Dammon.

Morris Armstrong, CFP, ChFC, head of Armstrong Financial Strategies in New Milford, Conn., says he has worked with clients for years to help them understand this concept.

"It is human nature to look at an 'account' as opposed to a portfolio," he says. "That is why many people choose to ignore the work required to allocate between taxable accounts and nontaxable accounts. But a portfolio is your entire holdings."

While each client's situation is of course different, he says, it doesn't make sense to stuff a retirement account with stocks that generate capital gains and dividends that enjoy preferred tax rates, only to be taxed at higher ordinary income rates upon withdrawal.

Apply that thinking to some of the big growth stocks of the last decade or two, which have split repeatedly while their prices have surged --


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Southwest Airlines

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-- and the savings, or loss, depending on how you look at it, is considerable.

Another reason to place stocks in taxable accounts, Armstrong notes, is that you cannot declare a loss in retirement accounts to offset any gains.

In addition, taxable accounts offer a potentially lucrative estate-planning feature. Upon your death, your heirs won't owe taxes on the capital gains on your appreciated assets. Instead, they start fresh with a new basis, or value for tax purposes, which is the market value as of the date of death.

Withdrawing money from an inherited IRA, in contrast, generates an income tax bill. So it makes sense, from an estate planning perspective, when possible, to put bonds -- whose value increases more slowly than equities -- in a retirement plan and faster-growing stocks in taxable accounts.

Not everyone has the luxury of having both kind of accounts. Most people need to look first to their workplace retirement plan, particularly if their employer offers matching funds.

"The key thing is to have a diversified portfolio," says Armstrong. "Every portfolio should have some combination of stocks and bonds. The days of being a cowboy with 100% equity are gone."

Even if his clients are young with 40 years to go before retirement, Armstrong has them put at least 20% in bonds and cash, with 80% in equities.

He notes that by law, every 401(k) plan must have at least one equity fund, one bond fund and one stable-value or money-market fund. In a rising interest market, as we're experiencing today, stable-value funds can offer better returns than bond funds, he says.

For those who have taken maximum advantage of their workplace retirement plans and can afford to invest in taxable accounts, Armstrong recommends investing in exchange-traded funds, or ETFs. These are securities similar to index mutual funds but cost less to acquire and trade like stocks. (Click

here to learn more about the ABCs of ETFs.)

Armstrong favors

iShares S&P500 Growth Fund

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, which tracks the

S&P 500

, and the

iShares Dow Jones Select Dividend Index Fund

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Christopher P. Van Slyke, CFP, with Capital Financial Advisors in La Jolla, Calif., adheres to the bonds-for-retirement-accounts view as well, but says it can't always be accomplished.

He has one client, the owner of a small business with several employees, who has $1.4 million in a defined benefit retirement plan for himself and the employees. While it would be best for the client to keep bonds in the pension account and invest in stocks outside the account, he would be violating his fiduciary duty to his workers if he didn't diversify the pension with stocks.

"We had to give up some of the tax benefit," Van Slyke says. "Taxes aren't the only consideration."

When it comes to investing in bonds, Van Slyke prefers the low-cost, index-style mutual funds from Dimensional Fund Advisors, available only through advisers or through employer-sponsored retirement plans, and from the Vanguard Group. He currently uses these short-term funds:

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DFA Five-Year Government Portfolio,

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Dimension Two Year Global Fixed Income Portfolio,

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, DFA Five Year Global Fixed Income,

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, Vanguard Term Bond Index Funds and

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Vanguard Short-Term U.S. Treasury Fund.

As a core equities holding, he uses

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Vanguard 500 Index Fund, then adds small-caps and international funds with the following:

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Vanguard Small Capitalization Value Index Fund,


Vanguard Developed Markets Index Fund,

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Vanguard Emerging Markets Stock Index Fund and

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Vanguard International Value Fund.

Steve Blankenship, CFP, principal with Heritage Financial Planning in Grapevine, Texas, says he tries when possible to have his clients put bonds in their retirement accounts. He even goes so far as to include large-cap dividend stocks, even though taxes on dividends are low by historic standards. "A tax is still a tax," he says.

To keep taxes and expenses low when investing in equities on the taxable side, he relies on passive or index ETFs for the large- and mid-cap portion of his allocations:

iShares S&P500 Growth Fund

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iShares Russell 1000 Growth Fund

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iShares Russell 1000 Value Index

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iShares Russell Midcap Index

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For two other asset classes, he uses actively managed funds. For small-cap stocks, he prefers

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Managers Funds Special Equity Fund and

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UAM Funds Trust FPA Crescent Portfolio; while for international equities he likes

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Oakmark International Fund and


Thornburg Investment Trust International Value Fund.

Blankenship believes that tax planning is essential to retirement saving for clients.

"They're spending more, they're retiring earlier and they're living longer, and that's a recipe for disaster," he says. "I need to help them pick up and retain as much return as possible."