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As an investor, you probably know about asset allocation -- the mix of stocks, bonds, and cash you hold. But have you ever considered asset location?

To minimize taxes on dividends and interest, consider placing the most tax-inefficient investments in your tax-deferred accounts and the most tax-efficient investments in your taxable accounts.

Generally, the mutual funds that trigger the highest current taxes tend to be taxable money market and bond funds. That's because most of their total return comes from taxable interest income, which is taxed as ordinary income at the investor's marginal tax rate. Stock funds -- particularly index funds, growth-oriented funds, and, of course, tax-managed funds -- tend to trigger lower taxes because these types of funds generate more of their total return from capital gains. Long-term capital gains generally are taxed at a lower rate than ordinary income. As you might expect, balanced funds -- those funds that hold a mixture of stocks and bonds -- fall somewhere between the most and least tax-efficient funds.

So you should put taxable bond and money market funds in your tax-deferred accounts and your stock funds in taxable accounts, right? Generally, but not all funds fall neatly under those overall guidelines. That's why you have to examine each fund closely to understand its potential tax efficiency. An investment in a money market mutual fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market mutual fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in these funds.

Tax-deferred accounts
Consider your most tax-inefficient funds as potential candidates for your tax-deferred accounts, such as employer retirement plans and traditional IRAs. When you hold these types of funds in a tax-deferred account, you don't pay taxes until you withdraw from the account -- usually in retirement when you're likely to be in a lower tax bracket. Your taxable money market funds and bond funds clearly fit into this category -- at least the portion you don't need ready access to. Among your stock funds, value funds may be good candidates for your tax-deferred accounts because they generally invest in stocks that offer higher dividend yields than growth stocks.

Taxable accounts
Of the stock funds you own, those that generate the highest proportion of capital gains to dividends can be particularly well-suited for your taxable accounts. Growth funds, index funds, and tax-managed funds generally fit into this category. Why do these funds generate more capital gains? Instead of paying dividends to shareholders, growth companies typically reinvest a large percentage of profits in equipment, buildings, and other resources. As the companies grow, the value of their stock typically grows, and funds that eventually sell those stocks realize capital gains. For the bond or money market funds you need to hold at-the-ready in taxable accounts, you can use the Cut Taxes on Your Taxable Accounts strategies to shield income dividends from taxes.

Making a final determination
There are no hard-and-fast rules to determine which investments should go in which kind of accounts because the tax efficiency of any particular fund can be more or less than you might expect. Some value funds -- which you'd expect to be tax-inefficient -- are managed to operate tax-efficiently, perhaps by following a buy-and-hold strategy, making them appropriate for a taxable account. Some growth funds -- which you'd expect to be relatively tax-efficient -- are surprisingly tax-inefficient, perhaps because frequent trading by the fund's adviser is generating short-term capital gains, which are taxed as ordinary income. Factors such as investment methodology, cash flows into or out of the fund, and trading frequency may outweigh growth versus value in determining a fund's tax efficiency. As a final check on whether a fund is best held in a taxable or tax-deferred account, look at its after tax returns (that is, how much of a fund's pretax return you get to keep after paying taxes). The larger the difference between a fund's pretax and after-tax return, the less tax-efficient the fund -- and if you want to own it, the greater the likelihood you'd want to hold it in a tax-deferred account.