Location ? Once the holy grail only for real estate investors is fast becoming the mantra for every stock, bond, and mutual fund investor. Experts and studies now recognize managing asset location is second only to asset allocation in determining the success of your investment returns.

Importance of Asset Location:
Asset location is a cornerstone to success for a simple reason. Taxable accounts differ from tax-deferred accounts {401(k), IRA and similar retirement}. Taxable accounts require you to pay income tax on every dividend and capital gain generated by your investments. This tax substantially reduces the amount of reinvestment and annual investment growth. On the other hand, retirement accounts defer taxes allowing returns to compound without penalty and at a substantially faster rate. Asset location refers to the optimal placement of securities between taxable and tax-deferred accounts. Good choices reward investors with long-term compounding and significantly higher returns. Poor choices, or more commonly, no choice, leads to below average results.

The effects are striking. Investors lose up to 20% of their after-tax returns by mislocating investments in the wrong type of account. So says a recent study from three finance professors Robert Dammon and Chester S. Spatt, of Carnegie Mellon University, and Harold H. Zhang of the University of North Carolina. The professors analyzed two asset classes, stocks and bonds, to determine suitability for investing within tax-deferred accounts. Their conclusion? Investors should keep equities in taxable accounts and bonds in tax-deferred accounts, to the greatest extent possible. Young investors stand the most to gain by following such advice. Three of the most powerful elements of investing -- dividends, deferred taxes, and compounding interest ? combine for a staggering effect to retirement income.

Unfortunately, the typical investor never takes advantage of all three benefits. A recent Federal Reserve survey shows Americans invest their taxable and tax-deferred accounts with identical securities. People focus on individual accounts rather than their entire portfolio. They ignore the benefits of allocating investments among different accounts and wind up with several accounts all holding the exact same thing. To their detriment, nearly half of all investors own bonds in taxable accounts and stocks in tax-deferred accounts.

Why asset location works:
Tax efficiency is more important than ever. Two recent changes have driven asset location strategy. Last year's tax cut, the Jobs and Growth Tax Relief Reconciliation Act of 2003, slashed top tax rates on dividends from 35% to 15%. Those same dividends, however, would be taxed at the ordinary rate (up to 35%) when withdrawn from a retirement account. The new law further cut taxes on capital gains from 20% to 15%. Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or equity mutual funds within a taxable account.

Similarly, fixed-income investments (e.g. bonds) and real estate trusts generate a regular flow of cash. These interest payments are subject to the same ordinary income tax rates of up to 35%. A tax-deferred retirement account provides investors with the best possible shelter for such securities and their resulting profits.

Which investment goes where?
Fortunately, your asset location strategy can be relatively simple. Place highly taxed assets in the tax-deferred accounts first. Anything left over can go into the taxable accounts. From the academic study, the professors concluded with three general rules to help with the decision process. First, locate taxable bonds, real estate investment trusts (REITs) and related mutual funds into tax-deferred accounts. Second, locate stocks and equity mutual funds into taxable accounts ? even if you are an active trader and generate substantial short-term gains. Third, never buy a municipal bond until you completely fill tax-deferred accounts with taxable bonds or REITs. The combination of compounding and deferring taxes on the higher yields of corporate bonds is. If all this sounds a little overwhelming, just consult the table below.

Table 1: Asset Locations for High Returns and Minimal Taxes.

TAXABLE ACCOUNTS
-- Stocks
-- Tax-free or tax-deferred bonds (munis, treasuries, and savings bonds)
-- Mutual funds investing in stocks or tax-advantaged bonds

TAX-DEFERRED ACCOUNTS (traditional IRAs, 401(k)s, and deferred annuities)
-- Taxable bonds (corporates, zeroes, TIPS, and high yields)
-- REITS (Real Estate Investment Trusts)
-- Mutual funds investing in taxable bonds or REITS

Two exceptions are worth noting. First, qualified distributions from Roth IRAs are tax free. Generally speaking, place assets with the greatest potential for returns inside a Roth. Second, if a 401(k) or IRA holds all (or nearly all) your investment money, throw this article away and focus only on asset allocation.

Summary:
You, as an informed investor, can take control over taxes and related expenses to your investment returns. Allocate your investments to reduce risk and increase returns. Locate your investments by managing all your accounts to minimize the tax drag on your financial returns.

Tim Olson

Mr. Olson is the editor of The Asset Advisor, a financial investment service providing proven strategies for no-load mutual fund investors. He brings 26 years of education and experience from Stanford University, Ernst & Young financial consulting, personal wealth management, and venture capital investing.