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%.
Next, you can think about keeping any taxable bonds or bond funds in those retirement accounts. Start with the least tax-efficient investments first, such as high-yield bonds, and work your way down. Remember: The more income you get off a bond fund, the bigger the tax liability. Then you're left with your regular old taxable brokerage and mutual fund accounts. Index funds, tax-managed funds and stock funds that have historically delivered low taxable distributions should go there. And, of course, municipal bonds, which already deliver tax-free income, can be kept in those accounts as well. So you should keep taxes in mind, but you cannot let them dictate what you should buy.