The Daily Dow
Friday, August 29, 1997
by Robert Sheard
LEXINGTON, KY. (Aug. 29, 1997) -- I received a very intriguing question in the message folder this morning, so I thought I'd take the chance today to expand on the scenario proposed there.
The questioner has a company retirement plan tied to an Index fund, with matching funds coming from his employer. Since a 401(k) plan is tax-deferred and the employer is matching his contributions, it's a sweet deal. But his question concerned extra money beyond the level his employer would match. Would that extra money be better off in an index fund in his tax-deferred retirement plan, or should he pay the taxes now and opt for the Foolish Four?
Let's say he has an extra $500 a month from his salary that he can put away (pre-tax) into his 401(k). If the market index returns the same average rate for the next 25 years that it has since 1971, his investment would grow at approximately 13.3% a year. By the end of the 25 years, his total would be $1,036,583. Remember, however, that this is pre-tax money, so he still has a tax liability built into that total. When he withdraws that money (either all at once, which is unlikely, or a bit at a time), the withdrawals are taxable as ordinary income -- let's assume this at the lowest current tax bracket of 15%. The tax liability hidden in that $1.04 million is $155,487. His real portfolio value, then, is $881,096.
What would happen, though, if he opted to pay his taxes as he goes for the extra $500 and invest it in the Foolish Four? Let's say he's currently in the 28% tax bracket. He'll have to pay that tax immediately on the $500 of monthly income, so he really only has $360 to invest each month.
With the historical rate of return for the Foolish Four (since 1971) at 22.9% and the capital gains tax rate now at 20% (for 18-month holdings), his annualized after-tax return would be approximately 18.3%. So putting that $360 away each month at an after-tax return of 18.3% over 25 years would yield a portfolio total of $1,679,025, nearly double the alternative plan.
I'm sure a tax expert will flame me for leaving out something in this equation, but the general point remains valid. As attractive as tax-deferred accounts are, sometimes it pays to shell out the taxes as you go if it means you're able to command a significantly higher annual return.
In this case, the ideal situation would be for him to fund the 401(k) to the extent that his employer will kick in matching funds (an automatic return from da boss), and then fund an IRA account (such as the new Roth IRA) to its limit using the Foolish Four. Anything left over each month can then be profitably invested using the Foolish Four in a regular taxable account, which would still fare better over the long haul than putting the extra money in an index fund through his 401(k) plan (assuming history is any guide).
So, check out all of the possibilities for your savings plans. Sometimes tax-deferred plans may actually prove a weaker alternative than paying the taxes as you go if the investment choices in that tax-deferred account are mediocre. Fool on!
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________
Stock Change Last -------------------- T - 5/16 39.00 GM -1 62.75 CHV -1 5/8 77.44 MMM -1 1/16 89.88
Day Month Year
FOOL-4 -1.30% 1.13% 7.11%
DJIA -0.94% -7.30% 18.21%
S&P 500 -0.46% -5.75% 21.43%
NASDAQ +0.38% -0.41% 22.94%
Rec'd # Security In At Now Change
1/2/97 153 Chevron 65.00 77.44 19.13%
1/2/97 179 Gen. Motor 55.75 62.75 12.56%
1/2/97 120 3M 83.00 89.88 8.28%
1/2/97 479 AT&T 41.75 39.00 -6.59%
Rec'd # Security In At Value Change
1/2/97 153 Chevron 9945.00 11847.94 $1902.94
1/2/97 179 Gen. Motor 9979.25 11232.25 $1253.00
1/2/97 120 3M 9960.00 10785.00 $825.00
1/2/97 479 AT&T 19998.25 18681.00 -$1317.25
CASH $1009.44
TOTAL $53555.63