You are deciding how much to invest in your 401(K). The IRS allows you to invest

Question

You are deciding how much to invest in your 401(K). The IRS allows you to invest a maximum of $18,000 every year until retirement. You have 25 years until you retire. Suppose you invest the maximum amount each year. You are considering two alternatives:

a) You can invest the $18,000 at one go at the end of the year, starting one year from now, making 25 payments in all

b) You can invest the $18,000 broken up by months ($1,500 per month), with the first payment made one month from now, making 300 payments (25*12) in total

If the interest rate you earn on your investments in the 401(K) is 8% EAR, how much will you have at the end of 25 years under each alternative? Why is the value higher under one alternative than the other?

Explanation / Answer

a. N = 25, PV = 0, PMT = 18000, rate = 8%

use FV funciton in Excel

future value = 1,315,906.92

b. N = 300, PV = 0, rate = 8%/12, PMT = 1500

use FV function in Excel

future value = 1,426,539.59

since the monthly payments start accruing interest earlier than a single end of year payment, the value of the former after 25 years is more

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