Building the Right Foundation

Given the opportunity to design their dream home, most people would probably want a sound structure above all--a building that will stand the test of time.

Yet when it comes to their portfolios, many people spend most of their effort worrying about the minutiae of their individual securities, with little regard to their investment infrastructure overall.

But that construction--how you arrange the accounts that are the building blocks of your portfolio--may be more important in determining the long-term growth of your assets than the specific investment choices you make.

Think of all the accounts through which you can invest money today. There’s the company-sponsored 401(k) retirement plan, the tax-deductible IRA, the nondeductible IRA, Roth IRAs, education IRAs, annuities and regular taxable accounts.

Many investors also are eligible for deferred compensation and company stock options.

Even if you know which stocks and bonds you want to own (and that’s a big if) and even if you know how much you should allocate to stocks versus bonds versus cash (another big if), what is supposed to go where?

For instance, if you conclude that the most appropriate asset allocation for you is 70% of your portfolio in stocks, 20% in bonds and 10% in cash, is the best place for your bonds now a Roth IRA--or some other account?

It may matter a lot someday: William Reichenstein, a finance professor at Baylor University in Waco, Texas, has calculated how two people can invest the same amount of money in the same stock and bond funds, yet one ends up with 26% more money at retirement.

How? One puts the stock fund in a tax-deferred account while holding the bonds in a taxable account. The other does the reverse.

Even seemingly simple choices may not be so. Say you decide that Reynolds Blue Chip Growth (the top-rated large-growth-stock mutual fund in our special Morningstar tables that begin on page S11) is worth owning.

You could just buy it in a taxable account. But you might be better off, all things considered, stocking up on a similar blue-chip fund already available in your 401(k)--except that you haven’t bothered to look.

For many investors, trying to keep track of it all “is just so confusing,” says Dee Lee, a financial planner and president of Harvard Financial Educators in Harvard, Mass.

And it may only get more complicated, as Congress and the states create additional savings options.

The best approach is to begin to regard all of your investment accounts--IRAs, 401(k)s, annuities, taxable accounts, even pensions and options--as a unified portfolio, experts say.

“You really need to aggregate the whole thing in your mind,” says Carol Gleckman, director of KPMG’s investment consulting practice in Los Angeles.

For some people, this will be relatively easy. That’s because for roughly half the nation’s 401(k) investors, their 401(k) balances represent the entirety of their investments, according to Vanguard Group.

For others, especially those with sizable 401(k) balances, multiple IRAs and multiple brokerage accounts, this will be harder to do. But the effort will be well-rewarded.

So--where to begin?

Start With Your 401(k)

There are several reasons why your 401(k), 403(b) or 457 retirement plan, if you have one available to you, is the best place to start arranging your portfolio.

One is that any contribution you make to a 401(k) is tax-deductible. And once in the plan, money will grow tax-deferred.

Furthermore, 89% of all 401(k) plan sponsors offer their employees some contribution match. Therefore, by not taking full advantage of your 401(k), you’re not only giving up valuable tax benefits, you could be leaving money on the table.

There’s also a strategic reason for starting with your 401(k). Unlike with IRAs, Roth IRAs, taxable accounts and other accounts in which you can place virtually any investment, your 401(k) places limitations on your investment options.

Say you want to invest in the Eaton Vance High-Income Fund. All you have to do is call Eaton Vance and do so. But if you want to invest in this junk bond fund through your 401(k), odds are you can’t--because it probably isn’t available in your plan.

According to a recent survey by consulting firm William M. Mercer, the typical 401(k) plan offers participants a choice of only eight investments. “Given that your 401(k) has limited choices, and given that you have to shop there, you should take the best of what’s offered there,” says Meloni Hallock, a partner at Ernst & Young’s financial counseling group in Los Angeles.

In other words, rather than convincing yourself that you absolutely must invest your 401(k) money in a large-growth-stock fund or in a government bond fund, look for the best possible investments in your plan, and take advantage of them foremost.

Whether you go with stock or bond funds, John Rekenthaler, director of research for Chicago-based mutual fund tracker Morningstar Inc., recommends using the 401(k) to invest in core holdings--those investments that anchor your portfolio and that you’ll hang onto for years, if not decades.

“You should treat your 401(k) money like your holy ground,” Rekenthaler says.

Traditional IRAs

Like a 401(k), an IRA holds your retirement savings. So you should use them to round out your core, long-term holdings, advisors say. (People who aren’t eligible for a 401(k) may have no other choice, of course.)

But which core holdings should you put into an IRA?

If you have a 401(k), take your cues from it. For instance, if you have a good large-value-stock fund and a good corporate bond fund to invest in through your 401(k), use the IRA to invest in asset choices that aren’t as well represented in the 401(k)--perhaps smaller growth stocks.

An old debate is whether it’s better to put income-generating bonds in an IRA, while leaving your stocks and stock funds in taxable accounts, or vice versa.

By sheltering bonds in an IRA you defer taxes on income that otherwise would be taxed at your ordinary federal marginal tax rate (up to 39.6%).

Meanwhile, stock funds that generate long-term capital gains in a taxable account face a top federal tax rate of just 20%. Shelter those gains in an IRA instead, and you may pay a higher tax rate when you take the gains out in retirement, since all money eventually withdrawn from a traditional IRA is taxed as ordinary income.

Yet Baylor’s Reichenstein argues that in general, stock funds belong in a tax-deferred account because stock funds grow significantly faster than bond funds, and stock fund managers often realize big capital gains (triggering taxes) by turning over their portfolios frequently.

Over time, his calculations show, the ability to defer taxes on rapidly growing stocks more than makes up for the higher tax rate you’ll pay on the money upon withdrawal.

For example, Reichenstein says, by putting $10,000 into a stock fund in a tax-deferred account and another $10,000 into a bond fund in a taxable account, you’ll end up with $232,734 in 30 years. But if you put the stock fund in the taxable account and tax-shelter the bond fund, you’ll have just $185,159 after 30 years.

(This assumes: annual returns of 12% for the stock fund, including a 2% dividend yield; annual returns of 7% for the bond fund; a combined state and federal income tax rate of 35%; a combined state and federal capital gains tax rate of 27%; and that the stock fund realizes 25% of its capital gains every year--a conservative figure.)

“The question you have to ask yourself is, do you want to tax-defer the lower- or higher-returning asset?” Reichenstein says. “That higher return, compounded over long periods of time, really makes the difference.”

So should stocks always be in tax-deferred investments? The answer depends on a number of variables. Among them:

* Your income tax bracket. The higher your bracket, the greater the benefit of using your IRA to defer taxes on bond income.

* Your tax rate when you withdraw money from the IRA. The lower your bracket in retirement, the less damaging it will be to convert capital gains taxes into income taxes through an IRA.

* Your returns, or how rapidly your stock investments grow. In Reichenstein’s example, the stock fund grew at 12% and the bond fund at 7%. If the spread was wider, it would strengthen his argument. If the spread was narrower, or if bonds actually outperformed stocks, the argument would be weakened.

* Capital gains. How often you and your fund managers realize capital gains on those stock investments by trading in and out of them.

With so many variables to consider, you’ll have to run countless spreadsheets to assess and reassess the merits of one strategy over another at any given moment. In other words, it might not be worth the effort.

However, here’s a good rule of thumb: If you do plan to put stocks in your IRA, use the IRA for growth-stock funds, which are more likely than value-stock funds to generate big gains and big capital gains taxes.

In other words, a high-turnover technology fund or a small-company-stock fund may be more appropriate for your IRA than a low-turnover index fund that simply tracks the Standard & Poor’s 500 index of blue-chip stocks, like the Vanguard Index 500 fund. These funds rarely sell any of their holdings.

And if you want to put bonds or bond funds in your IRA, don’t waste the tax deferral. Use the IRA for higher-yielding bonds, such as junk funds or high-quality corporates, rather than low-yielding bonds, such as short-term Treasuries.

Roth IRAs

There’s a big difference between a Roth IRA and a regular one. Money withdrawn from a regular IRA is taxed as normal income. Money withdrawn from a Roth, however, comes out tax-free, since you paid taxes upfront.

For investors who are eligible for Roth IRAs, “It’s almost a too-good-to-be-true kind of thing,” says Ernst & Young’s Hallock.

Because you won’t be converting capital gains into ordinary income when you use a Roth, “you want maximum growth in there,” argues Hallock.

Provided that your core portfolio--and the bulk of your assets--are in other kinds of accounts, that means using the Roth to invest in the highest-risk securities you can stand.

Also, because you can set up a Roth through any brokerage, this may even be an appropriate account in which to do short-term trading of individual stocks.

The drawback: Should you incur investment losses in a Roth or regular IRA, you can’t use them to offset capital gains, for tax purposes.

Bonds can still make sense in a Roth. But it’s best to place your highest-yielding bonds in these, because the income generated will never be taxed.

Taxable Accounts

One of the big reasons financial planners believe your so-called aggressive money belongs in tax-deferred accounts as opposed to a regular, fully taxable account has to do with human nature.

“People are less tolerant with [market] fluctuations in readily accessible money,” says Greg Schultz, principal with Asset Allocation Advisors in Walnut Creek, Calif.

“You can have a great aggressive plan for investing your taxable money, but what good is it going to do you if you’re just going to abort” when the market gets dicey or when you incur some big losses?

But does that mean your fully taxable investment accounts should hold only the most conservative investments?

That may make sense for many. Your money funds (or bank CDs) are your cushion--funds you want to access on demand.

Investors who trade actively, however, may take a different view of what belongs in taxable accounts. As noted above, any losses you incur in taxable accounts can be used to offset gains, for tax purposes. So if you’re inclined to day-trade, this may be the place to do it.

What’s more, if you want to hold a particular blue-chip stock for years, a taxable account may suit you just fine. It offers an automatic tax deferral, after all: You don’t owe taxes on any accumulated capital gains until you actually sell the stock (though dividend income would be fully taxed).

Still, many financial advisors recommend that, when it comes to stock mutual funds, taxable accounts are best for that portion of your portfolio you want to hold in passively managed index funds.

Why? Normally, index funds rarely sell their holdings. Therefore, they rarely realize taxable capital gains. That gives them a natural tax efficiency that is beneficial within a taxable account, and wasted in a tax-deferred account.

Other Accounts

Investors with pensions, deferred compensation or stock options will need to consider whether that future income should influence how they invest their portfolios today.

The key is to stop thinking only about the pieces, and--at least once or twice a year--focus on your entire investment infrastructure, financial advisors say.

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Retirement Strategies

The “Maximizing 401K and IRA Plans” panel at The Times’ third-annual investment conference May 22-23 at the L.A. convention center will focus on tips on the best ways to make use of tax-deferred options, from Roth IRAs to annuities. Call (800) 350-3211 for conference information, or see Page S19.