Vidya can invest $5,000 of after-tax dollars (AT$)directly in a taxable bond outside an IRA,or he can contribute the $5,000 to a nondeductible IRA and invest in the same bond through the IRA vehicle.In either case,the bond yields an annual 5% before-tax rate of return (BTROR).Vidya's marginal tax rate is 15%,and he expects it to remain so for the entire investment horizon of 20 years.What is the after-tax accumulation for the "bond inside the IRA" after 20 years?

Question

Quizplus · Accepted Answer

If Vidya invests the $5,000 in the taxable bond outside an IRA, he will have to pay taxes on the 5% annual interest income each year. His after-tax rate of return would be 5%*(1-15%)=4.25%. The after-tax accumulation for this option after 20 years would be:
AT$5,000*(1.0425)^20=$11,276.69

If Vidya contributes the $5,000 to a nondeductible IRA and invests in the same bond, he will not have to pay taxes on the 5% annual interest income until he withdraws the money from the IRA. Assuming he waits until the end of the 20-year investment horizon to withdraw the money, his after-tax rate of return would be 5%. The after-tax accumulation for this option after 20 years would be:
AT$5,000*(1.05)^20*(1-15%)=$12,027.02

Therefore, the best choice for Vidya is to contribute the $5,000 to a nondeductible IRA and invest in the bond through the IRA vehicle, as this option provides a higher after-tax accumulation after 20 years.

Vidya Can Invest $5,000 of After-Tax Dollars (AT$)directly in a Taxable