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Howdy fools -

This question is motivated by a column in the January, 2005 issue of Money magazine.

In the "Intelligent Investor" column (I think that's the one), Jason Zweig advocates favoring bonds over stocks in your 401(k) if you have investments in both a 401(k) and a traditional, taxable brokerage. The rationale is that interest income from bonds is taxable at up to 35%, depending on your tax bracket, while the maximum tax rate for capital gains is 15%.

By my reckoning, though, he's failing to factor in the fact that taxes are paid on the initial capital to be invested.

For example, assume that you have $1000 to invest, you're in the 35% tax bracket (both now and when you retire, for simplicity), you have 20 years until retirement, and your rate of return on the investment is 5% (i.e. you'll make the same investment either in your 401(k) or outside of it, the only question is where). My math looks something like this:

For the 401(k):
Available Investment $1000.00
Value at end $2653.30
Less income tax $928.65
Post-tax income $1724.64

For the non tax-advantaged account:
Available Investment $1000.00
Less income tax $350.00
Initial Contribution $650.00
Value at end $1724.64
Less initial contrib.
(already taxed) $650.00
Amount to be taxed $1074.64
Less cap gains tax $161.20
Cap gains retained $913.44
Plus initial principal $650.00
Post-tax income $1563.45

This analysis leads one to precisely the opposite conclusion advocated in the article.

So, my question is .... what am I missing?
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