Mr. Brown is in the 10% federal income tax bracket and wants to invest $8,000 in interest-earning assets. Mr. Black is in the 35% bracket and wants to invest $15,000. The current rate on a typical high-quality tax-exempt municipal bond is 5% and on a similar quality corporate bond is 6.5%. You are the financial advisor to both which investment would you recommend to each.

Question

Mr. Brown is in the 10% federal income tax bracket and wants to invest $8,000 in interest-earning assets. Mr. Black is in the 35% bracket and wants to invest $15,000. The current rate on a typical high-quality tax-exempt municipal bond is 5% and on a similar quality corporate bond is 6.5%. You are the financial advisor to both which investment would you recommend to each.

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1 answer
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Answer 1

Explain Bot answered
8 months ago

To determine the recommended investment for both Mr. Brown and Mr. Black, we need to calculate the after-tax income from each investment option.

For Mr. Brown:
1. Calculate the after-tax income from investing in a tax-exempt municipal bond:
a. Multiply the investment amount ($8,000) by the interest rate (5%) to find the pre-tax income: $8,000 * 0.05 = $400.
b. Since Mr. Brown is in the 10% federal income tax bracket, he will not owe any federal taxes on the interest income.
c. The after-tax income from the municipal bond is equal to the pre-tax income: $400.

2. Calculate the after-tax income from investing in a corporate bond:
a. Multiply the investment amount ($8,000) by the interest rate (6.5%) to find the pre-tax income: $8,000 * 0.065 = $520.
b. Since Mr. Brown is in the 10% federal income tax bracket, he will owe 10% of the pre-tax income in federal taxes: $520 * 0.10 = $52.
c. Calculate the after-tax income by subtracting the federal tax amount from the pre-tax income: $520 - $52 = $468.

Considering that the after-tax income ($400) from the tax-exempt municipal bond is higher than the after-tax income ($468) from the corporate bond, it is recommended for Mr. Brown to invest in the tax-exempt municipal bond.

For Mr. Black:
1. Calculate the after-tax income from investing in a tax-exempt municipal bond:
a. Multiply the investment amount ($15,000) by the interest rate (5%) to find the pre-tax income: $15,000 * 0.05 = $750.
b. Since Mr. Black is in the 35% federal income tax bracket, he will not owe any federal taxes on the interest income.
c. The after-tax income from the municipal bond is equal to the pre-tax income: $750.

2. Calculate the after-tax income from investing in a corporate bond:
a. Multiply the investment amount ($15,000) by the interest rate (6.5%) to find the pre-tax income: $15,000 * 0.065 = $975.
b. Since Mr. Black is in the 35% federal income tax bracket, he will owe 35% of the pre-tax income in federal taxes: $975 * 0.35 = $341.25.
c. Calculate the after-tax income by subtracting the federal tax amount from the pre-tax income: $975 - $341.25 = $633.75.

Considering that the after-tax income ($750) from the tax-exempt municipal bond is higher than the after-tax income ($633.75) from the corporate bond, it is recommended for Mr. Black to invest in the tax-exempt municipal bond.

In summary, it is recommended for Mr. Brown to invest in the tax-exempt municipal bond, while it is also recommended for Mr. Black to invest in the tax-exempt municipal bond.