investors to defer tax on salary income contributed to the plan and allows for tax deferral on all income and gains earned within the plan until they are withdrawn. When money is withdrawn it will be subject to ordinary income tax regardless of the nature of returns within the plan. Investors generally must begin to withdraw assets when they reach age 70. The advantage of a 401 (k) is tax deferral and the pretax compounding that it allows. Assuming an 8 percent return, 25 years of deferral reduces the effective tax rate from 39.1 percent to 21.8 percent.1 The disadvantages of a 401 (k) are (1) it converts long-term gains into ordinary income, and (2) the investor does not get the step-up in basis in which the government waives capital gains tax on unrealized appreciation in the estate of a deceased person. Income producing investments such as bonds and REITs benefit from the deferral offered by a 401(k) plan and suffer little from the disadvantages since they produce little appreciation. An equity index fund, on the other hand, produces a lot of unrealized capital appreciation plus some ongoing dividend income. The deferral of tax on dividends is helpful, but turning long-term gains into ordinary income and giving up the possible benefits of the step-up in basis can actually reduce the investor's expected aftertax return. As a general rule, investments that generate a lot of ongoing ordinary income derive more benefit from 401 (k)s and similar entities. In our examples we will assume that each investor will annually withdraw a fixed amount equal to 10 percent of the current balance. Mr. and Mrs. Jones, together, will withdraw $100,000 at the end of each year.2 Mr. Smith will withdraw $500,000 at the end of each year. We will deduct 40 percent for income taxes and credit the balance toward their annual spending requirements. GRANTOR TRUST A grantor trust is an entity that allows one person to transfer a gift to another while still retaining some control of the trust. The Joneses gave assets to their children through a grantor trust. The terms of the trust allow the parents some control over the timing of the children's access to the trust assets. The creation of the trust was a gift to the children that would likely have required the payment of $4 million in transfer tax if we assume a 50 percent gift and estate tax rate. However, now that the trust is established, the assets are out of the parents' estate and will not be subject to estate tax at their deaths. Further, and this is the point relevant to our analysis, the parents may continue to pay the trust's income and capital gains tax without that payment being construed as a gift subject to transfer tax. This !The effective tax rate is 1 - (After-tax return/Pretax return). In this example, the after-tax return is {[(1.0815)(1 - .391)] + 1}1/25 - 1. The +1 element is added to distinguish deferral of tax on investment return from deferral of tax on salary income contributed to the plan. 2Mr. and Mrs. Jones would be better off not withdrawing anything from the retirement account until forced to at age 70.5. To simplify our calculations, we will assume they begin withdrawing now.