Martha, who is in the 35% tax bracket, has $40,000 of before-tax income with which she wants to make a one-time investment. She wants to put $20,000 of this income in a deductible H.R. 10 plan, and she wants to invest any remaining aftertax income outside the H.R. 10 plan. Assume that Martha has sufficient self-employment income such that her contribution does not exceed the H.R. 10 contribution limit. Two investments are available: (1) a taxable bond yielding a 10% BTROR and (2) a nondividend paying stock that appreciates at a 10% annual rate before taxes. She is considering two alternatives:
1. Have the H.R. 10 plan invest in the stock, and Martha will invest in the bond outside the H.R. 10 plan.
2. Have the H.R. 10 plan invest in the bond, and Martha will invest in the stock outside the H.R. 10 plan.
The investment horizon is ten years with tax rates constant over this period. Capital gains upon sale of stock outside the H.R. 10 plan are taxed at 15%. However, if the stock is placed in the H.R. 10 plan, the H.R. 10 plan will sell the stock after ten years and distribute the proceeds to Martha, triggering ordinary income recognition to Martha. Assume no early withdrawal penalties on H.R. 10 plan distributions. Determine the total after-tax accumulation of Alternative 1 and of Alternative 2. Which of the two alternatives should Martha choose?