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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76106  
Subject: Re: 401k doing poorly Date: 9/27/1997 3:53 PM
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Greetings, Glenda, and welcome to Fooldom.

<<My 401k is doing poorly. The company doesn't contribute. I have no choice is picking the funds. I have been in for only 3 or 4 years. I.m 59 and need to get things going now. Should I pull out and invest that money in stocks? 24 >>

Without the match from an employer, your advantage to the 401k is the exclusion of your contribution from current income and the tax deferral of earnings in the 401k. Depending on how your investments do, it's quite conceivable you can do better investing in a taxable account. Just compare the after tax results with the 401k to see.

To show you what I mean, let's make a simple comparison between a tax deferred investment like a 401K plan and an ordinary taxable investment. Further, let's assume that ultimately you'll withdraw all your monies from the tax deferred account and be taxed on that amount at today's marginal tax rates. It's not quite that simple because in reality you'll decide how that money eventually comes out, maybe all at once, maybe piecemeal leaving the rest to compound,
but for this simplistic analysis it's close enough. Now let:

TR = your marginal tax rate
Ra = the return you expect in the after-tax investment
Rp = the return you expect in the tax deferred investment

Any earnings on the after-tax account will be taxed. Therefore, the equivalent rates of return in a tax deferred or after-tax account can be expressed as (1-TR)Ra = Rp, which can be restated as Ra = Rp / (1-TR). This formula gives you the rate of return you need in an after-tax account to
equal the return you would get in a tax deferred account after it, too, had been taxed at some point in the future. An example might be in order here.

Let's say I'm in a 28% federal tax bracket, I get no match from my employer, I deposit $100 into my tax deferred account, and expect to earn 10% on my deposit. What rate of return do I have to get in an after-tax investment to equal what I'm getting in that plan? Well, by using the formula, I get:

Ra = Rp / (1 - TR)
Ra = 0.10 / (1 - 0.28)
Ra = 0.10 / 0.72 = 0.138888 = ~13.89%

Therefore, if I deposited $72 in an after-tax investment (the equivalent of $100 deposited in a tax deferred account) and I earned at least 13.89% on that investment, I would do just as good after taxes as I would in a tax deferred investment earning a 10% return. If I could get more than 13.89%, I would do better.

Proof?? In the tax deferred account a $100 deposit would earn $10 at a 10% return, giving a total of $110. Withdrawing that $110 and paying taxes at 28% would leave $79.20. $72 in an after-tax account would earn $10 at 13.89%, or $7.20 after taxes, leaving $79.20 total in that account after taxes.

Regards.........Pixy
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