For many investors, the words "tax efficient investing" have been mutually exclusive.

The issue of efficient asset allocation between taxable and tax-favored investments is often ignored in the debate over the merits of annuities. Rather than condemn tax-deferred annuities as an investment vehicle in light of the new tax laws, a careful look should be made of the issue of tax-efficient investing.

When inside a tax-deferred account such as a 401(k) or a tax-deferred annuity, all assets are taxed the same while invested. When withdrawn, all assets are taxed as ordinary income at the owner's marginal tax rate. However, when outside such an account, different types of income are taxed very differently.

In a study for Stanford University's Center for Economic Policy Research, economists John Shoven and David Wise explain it this way: "à municipal bonds can be free of state and federal income taxation but carry an implicit tax (or lower interest yield) of about 28 percent. Realized capital gains are taxed more lightly than ordinary income à Accrued capital gains (perhaps resulting from retained earnings) are tax deferred (that is, they face no taxes until the gain is realized). Further, the cost basis of appreciated assets à is reset when they pass through an estate, so these capital gains can completely escape taxation."

Shoven and Wise suggest that investments that will be taxed most harshly should remain inside a tax-deferred vehicle. Thus, annuities are potentially an attractive alternative.

"For instance, if you want to hold a total portfolio consisting of zero- or low-dividend growth stocks, high dividend utility stocks and long-term corporate bonds, it makes sense to place all of the corporate bonds and utility stocks inside à before any of the relatively lightly-taxed growth stocks are placed inside," say Shoven and Wise.

What they are saying is that if you are going to invest in highly-taxed assets such as corporate bonds or utility stocks, they should be the first items in tax-deferred programs. To the extent that growth stocks yield unrealized capital gains, they already benefit from the tax-deferral feature.

The problem is investors aren't necessarily using the best vehicles for their funds. Are tax-deferred annuity investors following the investment strategy suggested by Shoven and Wise? The answer, according to a report by VARDS, a research group, is a resounding NO.

Prior to the 1980s, most tax-deferred annuity investments were in the fixed interest general accounts of insurance companies. The explosion of variable tax-deferred annuity products during the 1980s and 1990s has resulted in the offering of virtually the same profile of investment products as those in taxable mutual funds.

The VARDS study shows that the recent trend for tax-deferred annuity investors is to reduce their fixed account and income fund holdings and increase holdings in equities. Further, the largest equity category, growth funds, holds more than 28 percent of the assets. To the extent that these investments are from after-tax dollars that could have been invested directly into growth mutual funds, Shoven and Wise would say that this is an inefficient use of the tax-deferred annuity.