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.
To calculate the after-tax yields on the different investments, you need to consider the tax implications for each type of investment. Let's go through each option and calculate the after-tax yields:
1. Condominium:
The expected annual increase in market value is 5%. Since this is a capital appreciation investment, there aren't any immediate tax implications or yields. The gain from selling the condominium in the future would be subject to capital gains tax, but that is not considered in this calculation.
2. Municipal bonds:
The expected annual yield is 5%. Municipal bond interest is generally tax-exempt at the federal level, so the after-tax yield will also be 5%. No further tax calculations are needed.
3. High-yield corporate stocks:
The expected dividend yield is 8%. Dividends received from corporate stocks are generally taxable. Considering a marginal tax rate of 28%, the after-tax yield on high-yield corporate stocks would be (1 - 0.28) * 8% = 5.76%.
4. Savings account in a commercial bank:
The expected annual yield is 3%. Interest earned on savings accounts is taxable. Applying a marginal tax rate of 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 the expected dividend yield is 0%. Capital gains from selling stocks are subject to capital gains tax, but since there are no immediate dividends, there are no immediate tax implications. The after-tax yield would be the same as the expected annual increase in market value, which is 10%.
Now let's consider how to recommend the Brittens invest their $40,000:
- The after-tax yield on municipal bonds is 5%, so investing a portion of the $40,000 in municipal bonds would provide a stable and tax-efficient return.
- The after-tax yield on high-yield corporate stocks is 5.76%, which is slightly higher than the municipal bonds. This investment carries more risk, but potentially higher returns.
- The after-tax yield on a savings account is only 2.16%, which is relatively low. However, it provides liquidity and safety for emergency funds.
Therefore, a possible recommendation could be to invest $20,000 in municipal bonds, $10,000 in high-yield corporate stocks, and keep $10,000 in a savings account for liquidity and emergencies. This allocation balances risk, potential returns, and liquidity based on the given information. However, please note that investment decisions should also consider factors such as the Brittens' risk tolerance, investment goals, and time horizons.