You want to save for your child’s education, you can either choose an account that is federally tax free that earns 6% or a regular taxed invested that earns 7%. If your marginal tax rate is 25%, which should you choose? (Show your work)
we would get .75 * 7 % which is 5.25% if we chose the taxable account, so take the 6%
To determine which option is better, let's calculate the after-tax return for each account and compare them.
Option 1: Federally tax-free account earning 6%
Option 2: Regular taxed investment earning 7%
For Option 1, since the account is federally tax-free, the 6% return is not subject to any taxes. Therefore, the after-tax return for this option is the same as the pre-tax return, which is 6%.
For Option 2, the 7% return is subject to taxes at a marginal tax rate of 25%. To calculate the after-tax return, we need to deduct the tax amount. The tax amount can be calculated as:
Tax amount = Pre-tax return × Tax rate
= 7% × 25%
= 1.75%
After-tax return for Option 2 = Pre-tax return - Tax amount
= 7% - 1.75%
= 5.25%
Comparing the after-tax returns:
Option 1: 6%
Option 2: 5.25%
As you can see, the after-tax return for Option 1 (6%) is higher than the after-tax return for Option 2 (5.25%). Therefore, if your goal is to save for your child's education, you should choose the federally tax-free account that earns 6%.
Remember, when making financial decisions, it's important to consider other factors such as investment risk, individual circumstances, and long-term goals. It's advisable to consult with a financial advisor for personalized advice.