Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 294-297

But there is another key issue in investors' tax strategy. Qualified retirement plans [401(k), 403(b), IRA] have become critically important in the accumulation of family capital. Allocation of investments between a regular taxable account and a tax-deferred account has become a decision of great moment. Common sense would seem to suggest that income-oriented assets such as bonds should be placed in the tax-deferred account, and growth-oriented assets such as stocks, which have historically provided a large share of their returns as capital gains, should be kept in the taxable account. The logic is simple: current income is taxable at rates as high as 40 percent, whereas capital gains are subject to rates as low as 20 percent. Even more important, the realization of capital gains can be deferred indefinitely, effectively gaining an interest-free loan from the U.S. Treasury.

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Through their disregard for taxable shareholders, however, mutual funds have turned that common sense on its head. John Shoven has examined the allocation of stock funds and bond funds between taxable and tax-deferred accounts. He found that, over a 30-year period, most investors would accumulate the greatest level of terminal wealth by keeping stock funds in a tax-deferred account, and holding tax-exempt municipal bond funds in a taxable account. In his analysis, he assumed that gross returns on stocks were 12 percent and gross returns on municipal bonds were 5.4 percent.

Why wouldn't it be more rewarding to keep corporate bonds funds (which, in his study, returned 7.2 percent) in the tax-deferred wrapper, and place stock funds in a taxable account? After all, as long as the stocks' capital gains are unrealized, a stock fund won't sacrifice very much of its 12 percent gain to the IRS, and the investor will earn higher returns from corporate bonds than from municipal bonds.

That seemingly obvious policy simply doesn't work, mostly because the mutual fund industry pays little heed to the needs of taxable shareholders. Largely because of excessive turnover, a typical equity fund manager might transform a 12 percent pretax return into an 8.5 percent after-tax return. Through the serial distribution of long-term and even short-term gains, the manager needlessly sacrifices 30 percent of the stock market's gain to the tax collector. Given the distribution patterns of most equity funds, Professor Shoven concludes, the long-term investor can accumulate the greatest amount of terminal wealth by keeping stock funds inside the tax-deferred account and tax-exempt municipal bonds funds outside.

But it need not be that way with all mutual funds. The Shoven study also presents an illustration showing the after-tax returns of an account in an index-type fund with much lower portfolio turnover. Table 13.2, comparing Fund A, a conventionally managed stock fund, with Fund B, an index stock fund, summarizes Professor Shoven's findings. Both stock funds earn the same 12 percent pretax return, but Fund A distributes a full 10 percentage points of this return - 4 percent as short-term gains and income and 6 percent as long-term capital gains. Fund B distributes just 2 percentage points of its 12 percent return - 1 percent as income and 1 percent as long-term gains. Once Shoven accounts for the taxes due on these distributions, Fund B boasts a 2.3 percentage point advantage over Fund A - a 25 percent premium in after-tax return.

Armed with a tax-efficient stock fund, investors can accumulate more capital by inverting Professor Shoven's unconventional prescription, and holding taxable bond funds inside their pension account and tax-efficient stock funds outside their pension account. After a 30-year holding period, based on a $10,000 investment - $5,000 in stocks and $5,000 in bonds - the final value would be as shown in Table 13.3.


The use of a highly tax-efficient stock fund, then, would turn the equation upside down. An investor utilizing bonds in the pension account and stocks in a typical tax-inefficient fund outside accumulates $72,000, a $32,000 shortfall relative to the capital accumulated with the Shoven allocations. But when the same 50-50 strategy utilizes a tax-efficient stock fund, the accumulated totals $112,000, an excess of $8,000 relative to the capital accumulated with the Shoven allocation. The tables have been turned upside down. Using bonds in the pension account changes a shortfall of $32,000 into an excess of $8,000 (along with an estate tax advantage, since the cost basis of the taxable stock account is stepped up to market value at death).

Most investors may well decide to keep some stocks and some bonds in both taxable and tax-deferred accounts. But especially for those investing sizable sums - more than the $10,000 to $12,000 annually that, under current tax law, can be invested in tax-deferred accounts such as a 401(k) plan or a traditional IRA - the Shoven study offers sensible guidance to the optimal allocation of assets between a retirement fund and a conventional savings account. The decision must be a major focus of the investor's tax strategy.