Question

Would you prefer a fully taxable investment earning 8.1 percent or a tax-exempt investment earning 6.1 percent? (assume a 28 percent tax rate) why?

Answer 1

The tax-exempt investment with a 6.1 percent return would be preferable in this scenario due to its higher after-tax return compared to the fully taxable investment with an 8.1 percent return.

Step-by-step explanation:

To determine whether a fully taxable investment earning 8.1 percent or a tax-exempt investment earning 6.1 percent is preferable, we need to consider the after-tax returns of both investments. For the fully taxable investment, the after-tax return can be calculated by multiplying the pre-tax return by (1 - tax rate). In this case, the after-tax return would be 8.1% * (1 - 0.28) = 5.832%. On the other hand, the tax-exempt investment has an after-tax return of 6.1 percent. Since the tax-exempt investment has a higher after-tax return, it would be preferable in this scenario.

Answer 2

Prefer the 6.1 percent tax-exempt investment. Let's do the math and see why the tax-exempt investment is the better choice. For the 8.1% taxable investment, you get taxed at the rate of 28%. Which means that you only get to keep 100%-28% = 72% of your gains. So 0.72 * 8.1 = 5.832 which means your effective earning percentage is only 5.832% which is less than the 6.1% rate you get for the tax-exempt investment. Another consideration that wasn't taken into account for the question is the earnings on the taxable investment may push you up into a higher tax bracket. Which in turn increases the tax burden on your other investments. So the better choice here is the 6.1% tax-exempt investment even though that first glance the 8.1% investment looks higher.