Q. What is your opinion of owning mutual funds outside of a 401(k), IRA (or similar) type of account? I have a substantial amount of cash (about $265,000) that I parked on the sidelines just before the bubble burst. I would now like to get this money reinvested in a couch potato portfolio, either through ETFs or, preferably, Vanguard funds.

My father, a successful investor in his own right, always warned against holding mutual funds outside of retirement accounts due to a lack of control over how they are managed (short-term capital gains payouts, etc.) that result in tax time nightmares. I have significant 401(k) and IRA holdings and a diversity of individual stocks in brokerage accounts. I want to mitigate risk and minimize demands on my time to manage--- but do not want to cause myself any additional headaches at tax time. Your thoughts?

---S.N., by e-mail from Dallas


A. When the tax rate on dividends and capital gains was reduced to 15 percent last year the hazard of investing through taxable accounts was greatly reduced. I believe investors should have a "portfolio" of different account types: taxable, IRA, and Roth IRA. This will provide needed flexibility in dealing with tax issues.

There are two reasons for this.

The first is the enduring crazy-maker population in Washington. Regardless of party, they all seem to feel no year is complete without major changes in our tax laws. As a consequence, taxpayers need flexibility to cope.

The second, due to the same crazy-maker population, is the increasing number of retirees who must pay taxes on their Social Security benefits. The first round of these taxes was put on during the Reagan administration. The second was put on during the Clinton administration. That's true bi-partisan government.

The problem isn't the taxation of Social Security benefits. It is how most retirees will experience it. The tax is piggybacked onto income from other sources. As a result, taxpayers experience the tax as a high marginal tax rate on additional income. The rate can be as high as 46.25 percent, exclusive of state income taxes.

Basically, the same bi-partisan attention that has increased the amount we can save in qualified accounts---temporarily avoiding tax rates of 15 to 35 percent--- sets us up for a tax ambush in retirement when rates can hit 22.5 percent to 46.25 percent. That's why taxable accounts or tax-free Roth IRA accounts should be part of every investors portfolio plan.

You can get a rough idea of your vulnerability to this tax with a simple test: subtract half of your expected Social Security income from $32,000 (joint returns) or $25,000 (single returns). Here's an example. The 2004 Social Security Trustees Report tells us that a high-income worker (income around $53,000) retiring at 65 in 2004 can expect to receive an annual benefit of $18,701. Add $9,350 in spousal benefits. That makes the grand total $28,051. As a consequence, any additional income over $17,975 would trigger the taxation of Social Security benefits.

With a dividend yield around 1.7 percent, a broad index fund such as Vanguard Total Stock Market Index (also available as an ETF) doesn't present much of a tax problem. Its 2 percent portfolio turnover rate means you won't be facing any large or sudden capital gains distributions, either. Tax sensitive fixed income dollars can go into iSavings Bonds where they will earn (currently) 1 percent plus the rate of inflation, tax deferred.

And what about variable annuities?

They're non-starters.

First, their higher fees reduce your return as much as taxes would while income is being deferred. Second, when your deferred (but fee reduced) income comes out, it's taxed as ordinary income. The end result: real, spendable money will accumulate faster in any account that isn't a variable annuity. Skeptics can visit my website, www.scottburns.com, and play with the Retirement Account Horse Race, an on-line calculator that allows you to pit different account types against each other over 5 to 20 year periods.