Chapter 15, Problem 1TPC

This year, Mr. Joss accepted a job with BL Inc. He intends to work for only eight years and then start his own business. He has two options for accumulating the money he will need for this business.

• Option 1: He is eligible to participate in BL’s Section 401(k) plan and can afford to save $5,000 of his salary each year by diverting it to this plan. The plan earns 5 percent a year. Consequently, his plan balance in eight years will be $47,746 ($5,000 for eight years compounded at 5 percent).
• Option 2: He can take his entire salary in cash, pay income tax, and save $3,600 ($5,000 less $1,400 tax) in an investment fund that earns 5 percent a year. Because the annual earnings are taxable, his savings in the fund will grow at only 3.6 percent a year. Consequently, his fund balance in eight years will be $32,702 ($3,600 for eight years compounded at 3.6 percent).

Assuming a constant 28 percent combined federal and state tax rate, which option results in the greatest after-tax cash for Mr. Joss to begin his business?