Suppose there were two skills that you could acquire: tax planning and investing expertise. But suppose you could only learn one. You are faced with the following fact pattern.

You are endowed with $5,000 of after-tax cash and 20-year investment horizon. You have a marginal tax rate of 40% and you expect to face the same rate over the next 20 years. You expect that investing passively in an index fund will generate a 10% return each year, pretax, for the next 20 years. The future value of a $1 investment for 20 periods is as follows:

R Factor

6% 3.207

8% 4.661

10% 6.728

12% 9.646

14% 13.744

A. You choose to learn tax planning and invest passively. You invest in a 401(k) account (or similar tax-deferred vehicle) such that the after-tax cash cost of the investment is $5,000.

What is the after-tax future value of your investment? _____________________________

B. Now instead choose investing expertise. You actively manage a portfolio in your personal brokerage account (not in a 401(k) or IRA) and thus have no deferral of taxes on your returns. You hold no stock longer than 1 month.

What would your annual pretax return have to be to simply match the above basic tax planning?