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 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 AccountNon-Deductible IRARoth IRATaxable BondTax-Exempt BondPreferred 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?