Flex Your 401(k): Allocation

Don't worry if your retirement plan doesn't have all the investment options you need.
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Editor's note: As a special feature for Feburary, TheStreet.com offers a four-part series on 401(k) plans designed to help you maximize your retirement savings. Today is Part 2. Part 1 was on maximizing your contributions. Here's Part 3..

If you're already contributing as much as you can to your 401(k), the next step toward maximizing your retirement savings is to get the right asset allocation.

Having a mix of investments from various asset classes such as stocks, bonds and cash spreads the risks around, reducing the volatility of your portfolio. But the exact mix depends on how many years you have left before you retire to grow your portfolio and how much volatility you can stomach in the meantime.

More and more retirement plans are offering options, such as target-retirement funds, that make this easy by providing one-stop exposure to a mix of stocks, bonds and other assets. All you have to do is pick the offering that corresponds to the date you expect to retire. The fund becomes increasingly more conservative as the target date approaches, shifting money out of stocks and into bonds.

If you think this kind of fund is too conservative or if putting your portfolio on autopilot doesn't appeal to you, another option is to select a mix of investments that achieve the desired asset allocation. This is easier to do with index funds, which offer broad exposure to markets and charge relatively low fees, than with actively managed funds or stocks. Either way, it's up to you to rebalance periodically.

But suppose you want to put 15% of your portfolio in, say, international stocks, and your 401(k) plan doesn't offer a foreign stock fund -- or the one it does offer is a dog? Don't despair.

"A common mistake people make is to balance their 401(k) and to make certain it's diversified among various asset classes," says Gary Schatsky, an attorney, CPA and former chairman of the National Association of Personal Financial Advisors. "It does not need to be balanced. Your investments do."

That means if you have some money to invest outside your 401(k), you can put it to work in the foreign stock fund of your choice and use the money inside your 401(k) plan to get exposure to other asset classes.

Ideally, you can purchase the investments that aren't available in your 401(k) through another kind of tax-deferred account, such as an individual retirement account, to maximize the effect of compounding returns.

One thing to keep in mind when you're looking at your total portfolio is that different kinds of investment returns are taxed at different rates. Interest and short-term capital gains are taxed at rates as high as 35%, depending on an investor's income. But most investors pay 15% on qualified dividends and on long-term capital gains, or the appreciation on an investment held for more than a year.

So it makes sense to put investments that generate the biggest tax bills, such as taxable bond funds or funds that turn over their stock holdings frequently, in tax-deferred accounts.

Fran Kinniry, a principal at Vanguard's investment counseling and research department, says the fund company tries to teach clients that they have a limited amount of tax-deferred "shelf space" and that it should be used wisely.

Coming up tomorrow: avoiding withdrawals.

Allison Bisbey Colter joined TheStreet.com in 2006 from the New York office of Dow Jones Newswires, where she spent the previous seven years covering consumer finance, mutual funds and hedge funds. Prior to that, she worked in Europe for Dow Jones covering transportation from London and Italian capital markets from Milan. She is a graduate of Wesleyan University, where she received a BA in government.