Question

Marisa and Jennifer both attempted to put away $10,000 a year toward savings. Marisa used a 401(k) pension plan while Jennifer tried to do the same but was forced to pay taxes on that $10,000 in savings each year. Assuming that the process was the same each year for 40 years, how much will Marisa and Jennifer have at the end of the period, assuming identical investments providing pretax returns of 10 percent annually? The marginal tax brackets for both are 35 percent overall and for Jennifer’s investments 27 percent due to blending income with favorable capital gains rates. (Note: Be sure to use after-tax figures for Jennifer’s deposits and investment returns.)

Answer 1

For Marisa:

Marisa is using 401(K), so no tax at time of investment  

Number of investment (N)= 40; interest on investment (i)= 10; PMT= 10000; PV= 0; Compute FV=?

Using excel function :Fv(10%,40,-10000) =$4,425,925.26

Marisa would be required to pay a tax of 35% at withdrawal

Value of her retirement account = 4,425,926 * (1-35%) = $2,876,652

For Jennifer ,

tax at 35% on savings

Annual Investment = 10000(1-35%) =$6500.

she would have to pay tax at 27% on the gains made on investments.

Post tax return=10%*(1-27%) = 7.3%

Number of investment (N)= 40; interest on investment (i)= 7.3%; PMT= 6500; PV= 0; Compute FV=?

Using excel function :Fv(7.3%,40,-6500) = $1,402,308 ,no additional tax at withdrawal.