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I read an article by Stan Hinden in yesterday's Washington Post business section. The gist of his article was that he was surprised about how much tax he had to pay on his withdrawals from his IRA's and 401K plan. He seemed to be suggesting that one might be better to invest money outside of a retirement plan (except for a Roth IRA) so that they didn't get hit with the higher tax rate at withdrawal.

As I am getting closer to retirement, I find this of greater interest to me and decided to investigate it further. I generated a spreadsheet looking at a hypothetical investment of $10,000. One is in a 401K and the other is done with after tax dollars (I already am getting the maximum matching contribution from my employer). The after-tax contribution would be reduced to take into account the taxes I had to pay on it.

I made the following assumptions:

My marginal income tax rate (combined federal and state) would be 33% both before and after retirement.

Capital gains tax would be 22% to include the state tax on it.

11% compounded rate of return for both investments.

Here is the table:

401K Account Investment Account
$10,000.00 $6,700.00

Year Amount available after taxes
1 7437.00 7274.86
2 8255.07 7912.95
3 9163.13 8621.24
4 10171.07 9407.44
5 11289.89 10280.11
6 12531.78 11248.79
7 13910.27 12324.01
8 15440.40 13517.51
9 17138.85 14842.30
10 19024.12 16312.81
11 21116.77 17945.08
12 23439.62 19756.90
13 26017.98 21768.02
14 28879.95 24000.36
15 32056.75 26478.26
16 35582.99 29228.73
17 39497.12 32281.75
18 43841.80 35670.61
19 48664.40 39432.23
20 54017.49 43607.64
21 59959.41 48242.34
22 66554.95 53386.86
23 73875.99 59097.27
24 82002.35 65435.83
25 91022.61 72471.63
26 101035.09 80281.37
27 112148.95 88950.18
28 124485.34 98572.56
29 138178.73 109253.41
30 153378.39 121109.14
31 170250.01 134269.01
32 188977.51 148876.46
33 209765.04 165090.73
34 232839.19 183088.57
35 258451.50 203066.17

Running these figures out the 401K approaches a 28% higher return than the after tax approach. Is there an error in my reasoning or assumptions? Or is it that it is only a perception that the greater tax bite kills the 401K approach?

I also ran the figures out assuming a greater return for the non-tax advantaged account and discovered that after a number of years, the greater rate of return will correct for the up-front tax bite. Is this where the advantage of having a non-plan investment account comes in? From the greater rate of return one gets on this approach?
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