Your IRA and 401(k) (or 403(b) if you work for a non-profit) are great tools for deferring taxes, and have other advantages as well. But because they're labeled "retirement" accounts, people are much too likely to put the wrong investments in them. Here's how to use them correctly.

Because of rules designed to discourage people from taking money out until they approach retirement age, people assume that they ought to put their "long-term" investments in their 401(k). But that's the wrong way to think about it.

The key difference in a 401(k) or IRA account is not that it's supposed to be for your retirement. The key difference is that money that goes into the account--and money earned in the account--is tax deferred. If you let the fact that the accounts are called "retirement" accounts influence what assets you hold in them, you're unlikely to make maximum use of their key feature--and that amounts to throwing money away.

Use that tax deferral!

There are two steps to optimizing your various retirement accounts. The first is to get some money into them, and the second is to put the right investments into the right accounts.

First of all, you probably want to put as a big chunk of your regular income into your 401(k), as you can.

I say "probably" because there are a few reasons why you might want to limit how much money you put in your 401(k):

• Your income is very low. If your income is low enough that you're being taxed at 10% or less, there's a pretty good chance that you'd pay higher taxes when you take the money out of your 401(k) after retirement.
• Your income is very high. Both the IRS and your company limit how much money you can tax defer if you have a very high income.
• Your employer's plan is crappy. Some plans have high fees or poor choices of investments.
• You want to save money outside the plan, such as because you want to use it before you're retirement age.

Of course, if your company still provides a corporate match, that plays into the decision as well.  I've got a post on when NOT to put money in your 401(k) that talks about those issues in some detail. To what I'd say there I'd only add that federal income tax rates are currently at generational lows. That, combined with the current level of the deficit, suggests to me that future tax rates are likely to be higher than current tax rates--another reason why you might not want to put all your long-term savings in your 401(k).

Separate asset allocation from account selection

The allocation of assets among your various long-term goals is a completely different step from the selection of which account should hold which asset. Understanding this can add substantially to your wealth.

You probably have several long-term goals. Retirement (including early retirement) is one, but anything that requires years of saving qualifies as a long-term goal. (Examples: college savings for a young child, money to start a business, your dream home, a round-the-world cruise).

Investments for all your long-term goals can and should be managed together. All your assets support all your goals; you just confuse yourself if you start thinking that these stocks are for retirement while those other ones are to put a new roof on the house someday.

So, step one is to figure out your ideal asset allocation. This probably includes putting a large fraction of your investments in a broad-based, low-cost stock index fund, but may include investments in many other asset classes: mutual funds that invest in foreign stocks or dividend-paying stocks (or direct investments in such stocks), bonds, real estate, gold, silver, other commodities, etc.

Only after you've figured out how you want to invest your entire portfolio do you want to figure out which accounts should hold which investments.

Choosing compartments

The key to this step is to put income-earning investments in tax-deferred accounts.

Your asset allocation may include an investment in non-dividend paying stocks. They'd be part of a long-term investment strategy whose purpose is to produce growth over the next 20 or 30 years--but just because they're long-term does not mean that they should go in your 401(k)! Quite the reverse: a non-dividend paying stock that's a core holding in your portfolio should be in your regular brokerage account. If it does well you can go on holding it for years and years and won't have to pay any taxes until you sell--and when you do sell, you'll owe taxes at the low capital-gains rate.

Holding that investment in your retirement account would be crazy. First, since you already don't owe taxes while you're holding it, you'd get no benefit from the tax deferral. Second, when you withdraw money from a retirement account you have to pay taxes on it as regular income--losing the favorable tax treatment for capital gains.

(It doesn't work out any better if the investment does poorly--in your regular brokerage account you can use a capital loss to offset other gains before paying taxes, but losses in a retirement account are just losses.)

You don't want the compartment decision to drive your asset allocation--you already decided what investments you wanted to hold. But those assets should end up in compartments based on tax considerations. Interest-earning investments like bonds go in tax-deferred accounts. So do investments with frequent turnover--if you make trades in your regular brokerage account you have to pay taxes on your profits every year.

Dividends are a special case. Currently dividends are receiving favorable tax treatment, so you're probably better off keeping most dividend-paying stocks outside of your 401(k) at the moment. This is likely to change, though, so you'll have to monitor the situation.

If you have a good 401(k) plan with lots of low-cost fund choices, it should be easy to hit your target allocation with most of your interest-earning investments (and investments that you might trade actively) inside the plan.

Limitations

In an ideal world it would be straightforward to allocate things to the different categories: You'd put the things that earned interest into your 401(k) and IRA while keeping things that produced capital gains (and currently dividends as well) in regular accounts.

In the real world there are a bunch of constraints on that, the biggest being that many people, especially younger folks, have practically their whole wealth concentrated in their 401(k).

This happens almost automatically: You get a job, you direct enough money into your 401(k) to get the full corporate match (back when companies actually paid a corporate match), and then you spent most of your take-home pay. You can't hold your stock portfolio in your brokerage account (where you'd get the maximum tax advantage of the capital gains and dividend tax breaks) because you just don't have enough money outside the 401(k).

This and similar real-world considerations are going to limit your ability to get this exactly right--and that's to be expected. The important thing is to base your asset-allocation decisions on your best analysis of your goals and your expectations for the future. Below I've got a few tips for dealing with specific situations.

The main limitation on your ability to optimize your 401(k) plan has to do with the choices your employer offers within the plan. Happily, you can work around even a pretty mediocre plan's limitations, as long as you at least some of your long-term savings outside your 401(k).

First, take a close look at the investment choices you've got and compare them to your desired asset allocation. Maybe there's no bond fund, but there is a balanced investment fund that's half-and-half stocks and bonds. If you wanted 20% in bonds you could get that by putting 40% of your money into the balanced fund. (That would also put 20% of your money into stocks--which is fine, as long as your stock allocation is at least 20%, which it probably is.)

Second, where you really can't find the investments you need within the plan (no international fund, perhaps, or no gold fund) you have to cover that fraction of your asset allocation elsewhere--which is also fine, as long as you have some of your long-term investments outside the plan. If the investment is one that ought to be tax-deferred, see if you can't buy the appropriate asset within an IRA.

Generally, make hitting your asset allocation your number one priority. Maximum tax efficiency is a secondary consideration--but to the extent that you can keep your bond investments (and any investments where you make frequent trades) inside a tax-deferred plan, you'll come out ahead.

As a secondary matter, start saving some money outside your 401(k). As the sum grows, use it to invest for capital gains (and, for however long they remain tax-advantaged, dividends)--and simultaneously shift your 401(k) toward interest-earning investments that make maximum use of the 401(k)'s tax advantages.

For most people this will probably be a long-term problem: Unless you become quite wealthy, your 401(k) will always be larger than the amount of money you want to hold in bonds. But that's not a big problem. Just stick with your asset allocation and emphasize capital gains and dividends outside the 401(k).

Using a Roth

A Roth IRA is a special case. If you follow the rules (wait until your Roth is 5 years old and until you're 59-and-a-half), you can avoid paying any taxes on money earned in a Roth.

The upshot is that most of these issues don't really apply to a Roth. Just invest according to your asset allocation and don't worry about it.

Remember that tax rates always change (and everyone's individual tax situation is different), so be sure to check and understand how the rules will actually apply in your case.

Whatever mix of retirement accounts you end up using, don't let the fact that they're called "retirement" accounts distract you from the essential features that distinguish those accounts: the tax advantages. Taking maximum advantage of those features can add significantly to your wealth over the next few decades.

 [Update 6 August 2009:  This post was included in the Carnival of Personal Finance.]