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401(k) accounts are the
better vehicle for bonds

IF you're like many people, you have at least two separate "pools" of investment funds: 1) Your 401(k) or other tax-deferred, employer-sponsored retirement plan, and 2) your taxable brokerage account. Should you invest in both of them in exactly the same way?

Many people do just that. In fact, to fund both their 401(k) plans and their taxable accounts, investors put about 70 percent of their investment dollars in stocks and 30 percent in bonds, according to a recent study by Carnegie Mellon University. Is this a good idea? Not according to the study that claims this type of identical allocation can eat away between 15 percent and 20 percent of the cumulative value of your retirement accounts.

What's behind this kind of erosion? It's the different tax treatment of stocks and bonds. Bond interest is taxed at your ordinary tax rate (up to 35 percent), while the maximum rate for long-term capital gains and stock dividends is now just 15 percent. In contrast, all the money in your 401(k) plan will be taxed at your ordinary tax rate when you withdraw it, so if you put only stocks in your 401(k), you give up the more advantageous capital gains treatment. One possible way of improving the overall total value of your retirement holdings is to concentrate on stocks in your taxable account, while increasing the percentage of bonds in your 401(k).

For example, let's suppose that you plan to contribute the maximum amount of $14,000 to your 401(k) in 2005. (If you are 50 or over, you could put in $18,000.) Also, let's assume that you could afford to put another $2,000 into your taxable account, giving you a total of $16,000 to be invested. If you followed the 70 percent equities/30 percent bonds formula, you would put 30 percent of this $16,000, or $4,800, into bonds -- and to possibly receive favorable tax treatment, you'd put the entire $4,800 worth of bonds into your 401(k). You could then fill the remaining $9,200 of your 401(k) with stocks, and you could also invest your $2,000 in non-401(k) dollars in stocks.

We've used the 70 percent stocks/30 percent bonds figure as a "given." But is it right for you?

Not necessarily. During your working years, you may want to place a majority of your investment dollars into stocks; you need the growth potential, and, especially during the early part of your career, you have plenty of time to overcome the inevitable short-term "dips" in the market. As you move closer to retirement, you may want to shift some of your assets into more conservative vehicles, such as bonds or certificates of deposit (CDs). Yet you could easily spend two or three decades in retirement, so you will need your accounts to continue growing even after you retire -- which means you've got to have some exposure to stocks.

Ultimately, however, the respective percentages of stocks and bonds in your 401(k) portfolio -- and in your taxable account -- should be based on your individual risk tolerance, your long-term goals, and, as we've mentioned, your time horizon.

But once you've established an asset allocation that feels right for your needs, don't just put your investments on "autopilot." Keep monitoring them over the years, and adjust your holdings when necessary. By making the right moves over time, you can boost your chances for long-term success.