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The following investments are available to you: (a) a taxable bond with a coupon rate of 5% per year; (b) a tax-exempt bond with a

The following investments are available to you: (a) a taxable bond with a coupon rate of 5% per year; (b) a tax-exempt bond with a coupon rate of 3% per year; and (c) preferred (qualified) stock that pays a 5% annual dividend. All three investments are currently selling at their face (par) values, so their pre-tax yields are equal to their stated coupon (dividend) rates. Furthermore, asset values will not change over time. You can hold each of these assets in any of three savings vehicles: 

(a) a taxable account; 

(b) a non-deductible IRA; or (c) a Roth IRA. Recall that all distributions in excess of your investment in a non-deductible IRA are taxed at ordinary income rates, and all distributions from a Roth IRA are tax-exempt. 

Required: 

a. Assuming a 10-year holding period, compute the after-tax annualized rate of return (r) for each combination of investment and savings vehicle shown in the following table. Assume that dividends earned in a taxable account are taxed at 15%, and ordinary income is taxed at 35%. Also, for sake of simplicity, assume that all earnings are reinvested in the same asset.

Savings Vehicles

Investment

Taxable Account

Non-Deductible IRA

Roth IRA

Taxable Bond

Tax-Exempt Bond

Preferred Stock

b. For investments in taxable bonds, explain the rank ordering of r for each savings vehicle in terms of the relevant tax planning forces. Which savings vehicle is best and why? 

c. For investments in tax-exempt bonds, explain the rank ordering of r for each savings vehicle in terms of the relevant tax planning forces. Which savings vehicle is best and why? 

d. For investments in preferred stocks, explain the rank ordering of r for each savings vehicle in terms of the relevant tax planning forces. Which savings vehicle is best and why? 

e. Suppose that you have $12,000 to invest this year. You wish to hold a diversified portfolio of 50% bonds and 50% preferred stocks. Tax rules limit total contributions to all your IRA accounts to $6,000 per year. Which investments would you purchase and in which savings vehicles would you hold these investments? How much after-tax cash accumulation (F) would this strategy generate at the end of your 10-year investment horizon?

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