Conventional Wisdom Is Just Fine--Except When It Costs You Money

So you’ve decided which mutual fund to buy. Great. But which account are you going to use to buy that fund--your tax-deferred 401(k) or IRA, or an outside taxable account?

That’s not a small question. How you arrange investments and accounts within your total portfolio is as much a factor in your overall returns as the funds you pick.

Conventional wisdom says that because bond funds throw off income--income that is taxed at your ordinary income tax rate--you’re better off sheltering those funds. So, the argument goes, you should use your 401(k) retirement plan or IRA to buy bond funds.

Stock funds, on the other hand, expose you to capital gains. Gains on assets held for longer than 12 months are taxed at no higher than 20%. For most investors, that’s lower than their ordinary income tax rate.

So, the argument continues, if given a choice of leaving a stock fund or a bond fund in a taxable account, leave the stock fund there because it will be taxed at a lower rate.

Also, there’s this to remember: When you withdraw money from your IRA or 401(k) plan upon retirement, it will be taxed as ordinary income, no matter how it grew. So, by using your tax-deferred accounts to buy stock funds, you could be converting capital gains, taxed at a lower rate, into ordinary income, taxed at a higher rate.

Notes Colorado Springs, Colo., financial planner Jim Shambo: “I don’t want to shelter capital gains” just to expose them to ordinary income taxes.

But Baylor University finance professor William Reichenstein has been playing with the numbers recently, and he thinks conventional wisdom has it all wrong.

He offers this illustration: Say you have $2,000 to invest, and you decide to split that money evenly--$1,000 in a stock fund and $1,000 in a bond fund. You use your IRA or 401(k) to buy the bond fund and a taxable account to buy the stock fund.

Assuming the bond fund delivers annualized returns of 7%, and the stock fund, 12%--and further assuming that you’re in the combined 35% state and federal income tax bracket--you’ll have amassed $8,172.37 in 20 years’ time, after taxes.

Now, had you done the opposite, and used your 401(k) to buy the stock fund and the outside account to buy the bond fund, you’d have $8,704.99 after 20 years. That’s 7% more. (Remember, this is assuming that at the end of 20 years, you’ll withdraw all of that 401(k) money and pay 35% taxes on it.

Many of you may be in a lower income tax bracket in retirement, which would make the difference in this comparison that much greater. Plus, not all of you will need to withdraw all of this money at once.)

If you have an even longer time horizon, say, 30 years, this strategy would net you even more--26% more than had you listened to conventional wisdom.

How is that possible?

As in Reichenstein’s example, stocks have historically returned more than bonds--a lot more. And if you compound those higher returns tax-deferred over a long period of time, they more than make up for the higher taxes you’d pay, he argues.

Indeed, even with the recent reduction in the capital gains tax rate (which brought it down to 20%), “I still conclude that stocks ought to be held in the retirement plan,” Reichenstein said.

Putting aside the academic arguments, here are two practical reasons to consider using your 401(k) to buy stock funds:

* You’re likely to find a larger selection of stock funds than bond funds in your 401(k) plan. Indeed, many of the nation’s 300,000 or so 401(k) plans offer just one bond fund option--if that.

According to a 1997 survey by the Spectrem Group, a Connecticut research firm that tracks 401(k) plans, only one in seven 401(k) plans offered a corporate bond fund option and only one in five offered a short-term bond fund.

However, most 401(k)s offer a choice of several stock funds. As of last year, 86% of all plans offered a growth fund option; 84% offered a growth-and-income fund; 70% offered an aggressive growth fund (most likely a small-cap fund); and 68% offered a foreign stock fund.

So, if you’re committed to the conventional wisdom of putting bond funds in tax-deferred accounts, you may be forced (by lack of choice) to invest in a mediocre--or downright bad--fund.

* You’re more likely to trade in and out of stock funds than bond funds. So, by having stock funds in your tax-deferred 401(k), you can shift your money out of one equity fund into another without worrying about taxes. If you hold your stock funds in your taxable account, though, you’d owe Uncle Sam on each sale.

Obviously, not everyone is going to follow this advice. Indeed, you might have good reason not to--for instance, if your 401(k) plan offers better bond fund choices than stocks.

“The first question you always have to ask is: ‘Are the alternatives in your 401(k) attractive enough?’ ” Shambo says.

But if you are going to follow conventional wisdom and use taxable accounts to buy your stock funds, here’s some additional advice:

Try to stick with index funds or funds with low “turnover rates.”

Funds with low turnover (this means they do not trade stocks that often) and index funds rarely sell stocks. Thus, they don’t realize capital gains. And that means you’ll rarely see a tax bill--even though the fund is held in a taxable account.

*

Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.