What About Taxes?

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Conventional wisdom holds that it's almost always better to invest in a tax-deferred vehicle like a 401(k) plan or IRA 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, and this adds immeasurably to the positive power of compounding.

Because your earnings (and often the contribution) are untaxed until you begin withdrawing money in retirement, the government is in effect providing you leverage in the investment. This boost thus allows you to amass far more money for retirement than you could in a taxable alternative. Additionally, you control when it gets taxed, and at what rate, by deciding on the amount of the withdrawal and when to take it. By contrast, 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 general idea is true. But Fools know that all things are not equal. When should Fools elect to invest in a tax-deferred vehicle as opposed to a taxable alternative? We gave you a clue when in Step 3 we talked about 401(k) or 403(b) plans. In case you were snoozing, we said: 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.

Let's say your employer matches any contribution up to 6% of your salary. Fools would contribute that 6%, but beyond that they would compare the returns available in the plan investments to those outside of the plan.

Here's a simple comparison between a tax-deferred investment like a 401(k) plan and an ordinary taxable investment. Let's assume that ultimately you'll withdraw all your money from the tax-deferred account, and you'll 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, as they say in tuning a guitar, "It's close enough for blues.") Let's also 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.

For our example:

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 in 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). All right now, uncross those eyes. 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. Let's take an example.

Let's say I'm in a 28% federal tax bracket, that I get no matching contribution from my employer (or have already reached the maximum match), and that I deposit $100 into my tax-deferred account. I expect to earn 10% on that 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 well 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 401(k) 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. But remember this: If you choose an alternative to the 401(k), then you must be just as dedicated and disciplined within that investment as you would have been within the 401(k). That means you must make your deposits in that investment each and every payday without fail. It also means your deposit must increase at the same time and at the same rate as your pay does. Fail to adhere to that regimen, and you will neither equal nor beat the 401(k). The 401(k) demands these contributions and increases via automatic payroll deduction, so to keep pace with or to better that vehicle you must apply the same technique in any alternative.

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. It's called a Roth IRA and may be established anytime after January 1, 1998. With a Roth IRA, 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. This is an excellent vehicle for monies to be invested outside of an employer-provided plan.

Now on to Step 5.

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