This is a concept tool. It does not present tax advice or calculate accounting entries. It is intended solely to compare and contrast attributes of real estate and qualified plans. This tool demonstrates that assets subject to capital gains tax (such as a Condo) typically provide greater overall return (and usage benefits) as compared to assets subject to ordinary tax (such as a 401k). This is because: •Assuming an affluent client, assets subject to capital gains tax are typically taxed lower than ordinary rates. •Real estate investments provide a true tax advantage or shield. That is they generate return of cash to the investor. Contrast this to the tax deferring of a qualified plan where taxes are simply deferred and may or may not provide any tax advantage. •The Condo cash flows or tax advantages occur early on the time line and thus improve the Condo’s internal rate of return. |
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The two questions concerning rate of return are solved by iteration. We start with a guess about the required 401K rate of return. We run the spreadsheet solutions and calculate the IRRs. We test to see if the current guess makes the 401K IRR equal to the Condo (either with or without capital gains) IRR. It the guess is too large, we lower it. If the guess is too small, we increase it. We continue this process until the two IRRs are the same (within several decimal places). At that point, the guess is equal to the answer of the question. The two questions concerning IRR on the condo are solved by changing an assumption. The question specifies that we are assuming the final market value of the condo is the final balance of the 401K after taxes. Previously we has assumed the condo final market value was the before tax balance of the 401K. To solve for these two questions (the top question with capital gains and the bottom question without any taxes); we just modify the last month’s cash flow in the cash flows spreadsheet. There are two columns of cash flows. One column is for the condo with capital gain taxes. The other column is for the condo without taxes. The modification is to change the final market value to the final balance of the 401K after taxes for both sets of cash flows. Then we repeat the calculation of the IRRs. This provides two Condo IRRs. The first IRR is with capital gains. The second IRR is without taxes (of any kind). These IRRs are the solution to the questions. |