Assignment: Tax Issues Associated with Financial Planning

Understanding the tax consequences of your financial planning decisions is very important. These decisions may sometimes have life-long consequences in addition to a one-time result.

For example, when a person decides to save for retirement, there are tax consequences for each year when money is added to the account as well as when it grows. There are additional consequences later when that person decides to retire and use the money to live on.

This assignment looks at another example of tax issues associated with financial planning. You will look at the use of tax-exempt investment instruments such as municipal bonds, as an alternative to traditional investments, and corporate bonds or stocks.

Consider the following:

Bill Smith, a manager of a restaurant/bar in Los Angeles, is in the 25% marginal tax bracket and pays an additional 5% in taxes to the state of California. Bill has $20,000 invested in corporate bonds which is currently earning an average annual return of 7.5%.

Additionally, Bill also has another $20,000 invested in municipal bonds from the city of Los Angeles that are being used to redevelop depressed areas downtown. These bonds pay an average return of 5.4%.

Assume that in both cases, Bill earns the same returns as calculated on both the corporate and municipal bonds each year for the next 15 years.

Answer the following:

What is the after-tax return on Bill's corporate bonds for the current year?

What is the after-tax return on his municipal bonds for the current year?

Which investment earns more returns: corporate or municipal bonds?

What would the balance in each account be at the end of the fifteenth year?