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.
1. 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).
2. How would you recommend the Brittens invest their $40,000? Explain your answer.
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how much percentage will be added when investing in the condominium
To calculate the after-tax yields on the investments, we need to take into account the 28% marginal tax rate of the Brittens. Let's go through each investment option and calculate the after-tax yield:
1. Condominium:
Expected annual increase in market value = 5%
The increase in market value is not subject to immediate taxation. Therefore, the after-tax yield remains 5%.
2. Municipal bonds:
Expected annual yield = 5%
Municipal bond interest is generally tax-exempt at the federal level, so the after-tax yield remains 5%.
3. High-yield corporate stocks:
Expected dividend yield = 8%
Dividends from high-yield corporate stocks are typically subject to a 15% federal tax rate. Therefore, the after-tax yield is calculated as: 8% * (1 - 0.15) = 6.8%.
4. Savings account in a commercial bank:
Expected annual yield = 3%
The interest earned on a savings account is subject to federal income tax at the marginal tax rate. Therefore, the after-tax yield is calculated as: 3% * (1 - 0.28) = 2.16%.
5. High-growth common stocks:
Expected annual increase in market value = 10%
Expected dividend yield = 0%
Similar to the condominium, the increase in market value is not immediately taxed. Therefore, the after-tax yield remains 10%.
Now let's consider how to recommend the Brittens invest their $40,000. We'll compare the after-tax yields and consider their financial goals:
- Condominium: The after-tax yield is 5%, and it also offers the potential for appreciation in market value. However, purchasing a property requires a significant upfront cost and ongoing expenses, such as maintenance and property taxes.
- Municipal bonds: The after-tax yield is 5%, and they offer tax-exempt interest income. Municipal bonds are generally considered low-risk investments, suitable for conservative investors.
- High-yield corporate stocks: The after-tax yield is 6.8%, which is higher than the other options. However, high-yield stocks come with increased risk, as the higher dividends may indicate a riskier underlying business.
- Savings account: The after-tax yield is 2.16%, which is the lowest among the options. While savings accounts offer stability and easy access to funds, the low yield might not keep pace with inflation.
- High-growth common stocks: The after-tax yield is 10%, the highest among the options. However, these stocks do not offer any dividends, and their market value can be volatile.
Considering the Brittens' young age and long-term perspective, a well-diversified investment strategy may be appropriate. They could consider allocating their $40,000 as follows:
- Condominium: $10,000 (25% of the portfolio) for long-term appreciation potential and potential future home ownership.
- Municipal bonds: $10,000 (25% of the portfolio) for stability and tax-exempt income.
- High-yield corporate stocks: $10,000 (25% of the portfolio) for potential higher returns and dividend income.
- Savings account: $5,000 (12.5% of the portfolio) for emergency funds and short-term goals.
- High-growth common stocks: $5,000 (12.5% of the portfolio) for long-term capital appreciation.
Please note that this recommendation is a generalized approach, and individual preferences, risk tolerance, and other factors should be considered before making any investment decisions. It's always advisable to consult with a financial advisor who can evaluate specific circumstances and provide personalized guidance.