Bernie and Pam Britten are a young married couple beginning careers and establishing a household. They will each make about $50,000 next year and will have accumulated about $40,000 to invest. They now rent an apartment but are considering purchasing a condominium for $100,000. If they do, a down payment of $10,000 will be required.
They have discussed their situation with Lew McCarthy, an investment advisor and personal friend, and he has recommended the following investments:
The condominium - expected annual increase in market value = 5%.
Municipal bonds - expected annual yield = 5%.
High-yield corporate stocks - expected dividend yield = 8%.
Savings account in a commercial bank-expected annual yield = 3%.
High-growth common stocks - expected annual increase in market value = 10%; expected dividend yield = 0.
Calculate the after-tax yields on the foregoing investments, assuming the Brittens have a 28% marginal tax rate (based on Public Law 108-27, The Jobs and Growth Tax Relief Reconciliation Act of 2003).
How would you recommend the Brittens invest their $40,000? Explain your answer.
The after-tax rate of return is (1-t(k)), where t(k) is the marginal tax rate on income type k. Federal marginal tax rate on long term capital gains and dividends are (generally) 15%. Munis are generally tax free at the Federal level.
The rate of return of an asset is largely determined by risk and liquidity (and to some degree transaction costs). So, any investment decision should weigh in these factors.
To calculate the after-tax yields on the investments for the Brittens, we need to consider the tax implications for each investment.
1. Condominium:
The annual increase in market value is 5%. However, this increase in value is not subject to immediate taxation, as it is not realized until the property is sold. Therefore, there is no immediate tax impact on the potential increase in value.
2. Municipal bonds:
The expected annual yield is 5%. Municipal bond interest is generally tax-free at the federal level. Therefore, the after-tax yield on municipal bonds would also be 5%.
3. High-yield corporate stocks:
The expected dividend yield is 8%. Dividends from corporate stocks are subject to a 15% federal tax rate for most taxpayers. Therefore, the after-tax yield on high-yield corporate stocks would be (1 - 0.15) * 8% = 6.8%.
4. Savings account in a commercial bank:
The expected annual yield is 3%. Interest earned on savings accounts is subject to ordinary income tax rates. As the Brittens' marginal tax rate is 28%, the after-tax yield on a savings account would be (1 - 0.28) * 3% = 2.16%.
5. High-growth common stocks:
The expected annual increase in market value is 10% and there is no expected dividend yield. Capital gains from selling high-growth common stocks are subject to a 15% federal tax rate for most taxpayers. However, as there are no dividends, we are only concerned with the potential increase in market value. Therefore, the after-tax yield on high-growth common stocks would be (1 - 0.15) * 10% = 8.5%.
Considering the after-tax yields and the factors of risk and liquidity, here is a recommended investment strategy for the Brittens' $40,000:
1. Condominium: As the market value is expected to increase by 5% annually, investing in a condominium can provide both shelter and potential long-term appreciation. It is a relatively low-risk, long-term investment with moderate liquidity.
2. Municipal bonds: Investing a portion of the funds in tax-free municipal bonds can provide a stable income stream with a 5% annual yield and lower risk compared to other investments. Municipal bonds also provide tax efficiency as the income is generally tax-free at the federal level.
3. High-yield corporate stocks: Allocating a portion of the funds to high-yield corporate stocks can provide a higher yield of 6.8% after taxes. This investment carries higher risk but also offers the potential for greater returns.
4. Savings account in a commercial bank: Keeping a portion of the funds in a savings account can provide a safe and easily accessible option with a modest after-tax yield of 2.16%. This can serve as an emergency fund or provide liquidity for short-term needs.
5. High-growth common stocks: Investing in high-growth common stocks can offer the potential for substantial long-term capital appreciation. With an after-tax yield of 8.5%, this investment carries a higher level of risk and may be less liquid. It is important to carefully consider individual stocks and diversify the portfolio.
Overall, this recommended investment strategy balances risk and potential return, taking into account the after-tax yields of each investment option and the Brittens' goals and financial situation. However, it is important for the Brittens to consult with a financial advisor to tailor these recommendations to their specific circumstances and risk tolerance.