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Author: bacon Three stars, 500 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76237  
Subject: Re: Taxable vs 401(k) Date: 4/24/1998 9:06 PM
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<I am trying to decide if I should bump up my 401(k)
contribution (beyond the minimum required to get the full
employer match). And I can't figure out how to account fortaxes.
Assume a marginal tax rate of 31%, combined state &federal.

[snip]

Suppose I have $1000 to invest.Outside the 401(k), with FF:
$310 goes to tax, leaving $690 to invest. Gain of 16%
reduced by 31% tax = 11.04% after-tax. In ten years, $690
compounded at 11.04% grows to $1966
Outside the 401(k), with Keystone:
$310 goes to tax, leaving $690 to invest. Gain of 20%
reduced by 31% tax = 13.8% after-tax In ten years, $690
compounded at 13.8% grows to $2513
Inside the 401(k), with S&P: $1000 compounded at 12% grows
to $3100. Reduced by 31% tax = $2139.>

Your two alternatives to the 401(k) bracket the answer. First, recall that you get to pay taxes on the way back out of your taxable investment, although generally at cap gains rates rather than at income rates. That said, one way to find the indifference level between a taxed and a tax deferred investment is to divide the tax deferred return by (1-(your tax rate)). In your example, 12%/(1-.31) = 12%/.69 = 17.4%. Thus, your 12% return on your tax deferred vehicle (401(k))would have to be matched by a 17.4% return on a taxable alternative. A higher return makes the taxable alternative preferable, a lower return makes the tax deferred vehicle preferable.

HOpe this helps.

Eric Hines
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