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 = 2%.
Municipal bonds - expected annual yield = 3%.
High-yield corporate stocks - expected dividend yield = 5%.
Savings account in a commercial bank-expected annual yield = 1%.
High-growth common stocks - expected annual increase in market value = 6%; 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.
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To calculate the after-tax yields on the investments, we need to determine the tax implications for each investment.
1. Condominium: The increase in market value does not attract immediate taxes. However, if the Brittens sell the condominium and realize a capital gain, they will be subject to capital gains tax. For now, we assume no tax on the increase in market value.
2. Municipal bonds: Municipal bonds are typically exempt from federal taxes, including the interest earned. Therefore, the after-tax yield for municipal bonds would be the same as the pre-tax yield, which is 3% in this case.
3. High-yield corporate stocks: Dividends from high-yield corporate stocks are subject to taxes. The qualified dividend tax rate for the Brittens, assuming a 28% marginal tax rate, would be 15%. Therefore, the after-tax dividend yield would be 5% * (1 - 0.15) = 4.25%.
4. Savings account in a commercial bank: Interest earned on a savings account is subject to income tax. With a 28% marginal tax rate, the after-tax yield on the savings account would be 1% * (1 - 0.28) = 0.72%.
5. High-growth common stocks: The increase in market value of high-growth common stocks incurs taxes only when sold and there is a capital gain. Assuming no capital gain at this point, we do not consider any immediate tax liability on the increase in market value.
Now, let's analyze the suggested investments in terms of after-tax yields:
- Condominium: As mentioned earlier, we assume no immediate tax on the increase in market value. Therefore, the after-tax yield remains 2%.
- Municipal bonds: After-tax yield is 3%.
- High-yield corporate stocks: After-tax dividend yield is 4.25%.
- Savings account: After-tax yield is 0.72%.
- High-growth common stocks: No immediate tax liability taken into consideration.
Considering these after-tax yields, I would recommend the following investment strategy for the Brittens' $40,000:
1. Allocate a portion towards the down payment for the condominium since it offers a relatively stable increase in market value (2%) without immediate tax implications.
2. Diversify the remaining amount across the various investment options to achieve a balanced portfolio. For example, they could allocate a portion to municipal bonds for a guaranteed after-tax yield of 3% and a portion to high-yield corporate stocks for higher potential returns.
It's important to note that while high-growth common stocks may have the highest expected increase in market value (6%), the lack of immediate tax liability doesn't necessarily make it the best choice for the Brittens in terms of diversification and risk management. They should consider their risk tolerance and long-term investment goals before making a decision. Additionally, it's crucial to consult with a financial advisor to tailor the investment strategy to their specific circumstances.