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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 76237  
Subject: Re: Taxable vs 401(k) Date: 4/25/1998 11:51 AM
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Ray,

<< But how do I treat the immediate $310 "tax savings"? I
invest $1000 but my take-home pay is only reduced by $690.
Is it already fully accounted for, or not? >>

Yes, it's already accounted for by that reduction. It's part of the "dilemma" issue I've preached about so often in this folder. If you're gonna keep your take home pay the same and put everything on a tax equivalent basis, you have to solve for the rates of return in the before- and after-tax investments to do the comparison. Bacon (Eric Hines) was dead on with his remarks and formula.

As an additional reminder:

QUOTE:

Conventional wisdom holds that it's almost always better to invest in a tax-deferred vehicle like a 401k plan or IRA rather than in an after-tax investment. This gospel holds that even if the initial investment itself is made with money that's already been taxed, the earnings accumulate untaxed, which adds immeasurably to the positive power of compounding. Because your earnings (and often the contribution) are untaxed until you begin withdrawing money in retirement, in effect the government is providing you leverage in the investment. This boost thus allows you to amass far more money for retirement than you could in a similar taxable alternative. Additionally, you control at what rate and when it gets taxed by deciding on the amount of and when to make the withdrawal. In conventional investments, you are taxed on all money going in and on all dividends and gains in the year they are received.

All things being equal, that concept is true. Unfortunately, all things are not equal. And therein lies the dilemma. When should Fools elect to invest in a tax-deferred vehicle as opposed to a taxable alternative? That's easy. When it makes sense to do so. The trick, though, is deciding when it does. When looking at something like a 401k or 403b plan, we've already given you one clue. Use the plan at least up to the level where you obtain the maximum matching contribution from your employer. Don't turn down that FREE MONEY for the reasons we've already discussed. Beyond that level, though, or if your employer provides no match, it's a different story. Now you must look at the returns available in your plan investments as compared to those in everything else that's available outside the plan.

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. 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 or have reached the maximum match from my employer, and I deposit $100 into my tax-deferred account where I 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.

Conclusion: Use a 401K or similar plan to get the maximum employer matching contribution available. Beyond that level, compare your before-tax and after-tax investment options and select the one that provides the highest after-tax return.

The Taxpayer Relief Act of 1997 provides a unique opportunity to those of us who have reached the maximum contribution we wish to make to our employer plans. That's something called a Roth IRA that may be established on or after January 1, 1998. A detailed description of this vehicle may be found at http://www.fool.com/retirement/retirement.htm . The Roth IRA is one in which you may make a nondeductible deposit of up to $2,000 per year, allow the earnings to accumulate tax-free through the years, and ultimately withdraw all of the proceeds tax-free. Fools believe this is an excellent vehicle of choice for monies to be invested outside of an employer-provided plan. Using the Foolish Four as an example, $2K per year for 20 years at the historical return since 1971 of 22.1% means a $40K investment through the years turns into $588,281. All tax-free. Now that's Foolish!

The moral of this story is tax-deferral is nice. But it's not always the best deal in town.

UNQUOTE

Regards….Pixy
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