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The Future Value of Tax-Advantaged vs.Taxable Account

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Susan Lee who is 26 years-old has a new job with Inspiron. She is planning to start her own business in 8 years so she has two options to start saving money to open her shop:

1) She can participate in 401K plan that the company offers as part of the employee benefit package. She can afford to contribute $5,000 each year to her 401K plan. Her investment plan earns 10% a year. She estimates her plan balance will be $57,269 keeping in mind that she will contribute 5000 each year at 10 percent.

2) She can save $3,600 each year if she takes her entire salary in cash, pay income tax. Susan won't contribute to her 401k plan for 8 years but she has an investment plan that earns 10 % a year. She estimates that her saving funds in 8 years will be $37,304 because her annual income is taxable, her saving account will mature at 7.2%.

Please show the calculations for each of the option and explain which of these two options have the greatest after-tax cash to start a business (Susan has a constant 28% tax rate)

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Solution Preview

See attached Excel file.

Susan has an advantage in using the 401(k) plan which the problem does not even address. That is, she invests $5,000 per year but receives a tax ...

Solution Summary

Given a taxpayer's option to invest in a tax-advantaged or taxable account, this solution illustrates how to compute the financial advantage of the former over the latter.