Question

Genna is 60 years old and is bargaining with her employer over deferred compensation. In exchange for reducing her current year’s salary by $50,000, she can receive a lump-sum amount in 5 years, when she will retire. If she receives the $50,000 in the current year, she will invest in certificates of deposit that yield 5%. Genna is in the 28% marginal tax bracket in all relevant years. What is the minimum amount Genna should accept as a deferred pay option? [Hint: the compound interest factor is 1.1934.]

Answer 1

Assuming that tax is applicable in both - salary and interest:

If she receives the amount of 50000 in current year and invests in certificate of deposit:

Amount of salary receipt: 50000

Amount of tax = 50000 * 28% = 14000

Amount of investment in certificate of deposit = 50000 - 14000 = 36000

Interest rate net of tax = r * (1 - t)

= 5% * (100% - 28%)

= 3.6%

Value of investment after 5 years = 36000 * (1.036^5)

= 36000 * 1.1934

= 42962.4

Hence the salary she should receive after five years (deferred compensation) should atleast be 42962.4 after payment of tax on such compensation.

Amount of minimum pre-tax deferred compensation = 42962.4 / (1 - t)

= 42962.4 / (100% - 28%)

= 59670