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The Worst Funds for Your 401k

Reuben Gregg Brewer, The Motley Fool

If you are saving for retirement and your company offers a 401k plan, you had better make sure you take advantage of the opportunity. However, the 401k isn't perfect, and you need to think a little about what you own inside this account and what you own outside of it to take full advantage of the tool. Here are two mutual funds from industry giant Vanguard that you would be better off keeping in your taxable accounts.

Uncle Sam gets his due

There are a lot of things to like about the 401k account, most notably the tax deferral it offers investors. It's a huge benefit, allowing you to avoid income taxes on the pre-tax money you put into the account and the taxes that would normally be generated from buying, owning, and selling securities within the account. But you don't get to avoid taxes forever. When you pull money from a 401k, you pay taxes as if that money were regular income. This is roughly similar to the way a traditional IRA works.

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While you are stuffing money away for retirement paying taxes when you pull money out of your 401k may seem like a small issue, but it really isn't. It's something you need to think about from day one if you want to maximize your use of these accounts. If you don't, you could end up owing more to the government than you hope -- and no one wants to pay Uncle Sam more than they have to.

A couple of examples

The first type of fund that you should avoid owning in a 401k account, or a traditional IRA for that matter, is a municipal bond fund like Vanguard High-Yield Tax-Exempt Fund (NYSEMKT: VWAHX). There's nothing particularly wrong with the fund itself. It's cheap to own, with a meager 0.19% expense ratio, and it's beaten its benchmark over the trailing one-year, three-year, five-year, and ten-year periods. Since its inception in late 1978 it's provided investors with an annualized return of around 6.5%, a very solid showing for a bond fund.

If these are all good numbers, what's the big problem? The name says it all... The fund's goal is to provide a high level of federally tax-exempt income by investing in municipal bonds. If you own this fund, or any similar municipal bond fund for that matter, you are putting tax advantaged income into an account that will turn that cash into taxable income when it comes time to pull the money out. You are, effectively, destroying the tax advantage provided by Vanguard High-Yield Tax-Exempt Fund, or any similar muni-bond fund, if you put it inside a 401k or a traditional IRA.

VWAHX Total Return Price Chart

VWAHX Total Return Price data by YCharts

This is the same problem that you'll find with a fund like Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (NYSEMKT: VTCLX). It is super cheap to own, with a minuscule 0.09% expense ratio, has beaten its benchmark over the trailing 1, 3, 5, and 10 year periods, and provided an eye-pleasing annualized return of roughly 10% since its inception in 1994.

But like the muni fund above, the problem is that the fund specifically attempts to minimize the taxes that its shareholders pay. Funds that attempt to keep shareholder taxes low make key changes to their investment approach to achieve that end. For example, Vanguard Tax-Managed Capital Appreciation Fund actually attempts to track the Russell 1000 index, but does so with a sampling technique that avoids dividend-paying companies. That tends to create a heavier weighting in mid-cap stocks, which can be more volatile, but it also helps to keep taxable income low. For reference, Vanguard offers a small-cap version of this approach as well via its Vanguard Tax-Managed Small-Cap Fund Admiral Shares (NYSEMKT: VTMSX).

Other managed funds may attempt to minimize taxes by doing things like harvesting tax losses to offset capital gains. Another key investment tactic of these funds is to purposely hold stocks for at least a full year so they don't expose investors to short-term capital gains tax rates. Outside of a 401k, doing things like this is a huge benefit; inside of a 401k it's wasted effort since every dollar you pull out of a 401k is going to be taxed as income.

Be strategic

These are just a few examples of Vanguard mutual funds that aren't great fits for 401k accounts. But they aren't meant to be looked at as a specific "do not buy" list -- they are examples of the types of funds you can find at most major fund shops. You'll want to think carefully before you include them in your 401k or traditional IRA accounts. Any tax advantage offered by a muni fund or a tax managed stock fund will, effectively, be lost when you pull money from these two types of accounts, because all withdrawals are taxed as income. It's a small but important wrinkle that you need to keep in mind when you are selecting your investments and deciding which accounts you plan on owning them in.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.