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Author: maxb One star, 50 posts Old School Fool Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75383  
Subject: Re: 401(k) and foolishness revisited Date: 4/21/1998 1:31 AM
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<< TMFPixy Writes:
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. In a further nod to simplicity, let's agree that all gains in the taxable account will be taxed at ordinary rates even though we know that at least half would be taxed at the lesser capital gains rate.
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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.
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Ok, I've been thinking about this some more (perhaps too much :) and there's another factor not accounted for in this analysis.

This analysis holds true only if the money is removed from the tax deferred investment each year and taxes are paid at that point.

If its not, then in the first year, the difference between the $10 earned in the deferred account versus the $7.20 after tax, or ($2.80) is STILL in the deferred account to increase the basis for the following year.

So, for the second year, the tax deferred account would earn 10% of $110, or $21 while the after-tax account would get 13.89% of $79.20 or $11.

Compounded over 20-30 years of retirement savings this would be substantially in favor of the tax deferred account.

My math skills are not quite up to par at this late hour. Someone care to put forth the formula for calculating the after-tax rate required to account for the compounding over 20-30 years?

I'd love this to work out. I'm at a startup company that's too small to match contributions. The 401K plan is great for a company our size, but the mutual fund choices don't really excite me. I'd rather invest the money myself.

-max
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