Question

3. Suppose that you are going to save $4,000 of your income for one year, after which you will spend it along with any accumulated interest you earned. Assume that your marginal income tax rate is 30%. Consider the following two options: Option 1: Invest in a regular savings account earning 10% interest. Option 2: Invest in all Individual retirement account earning 10% interest Determine the after-tax value of your savings a year from now under both options. If the amounts are the same, explain why they're the same. If the amounts are different, explain why they're different.

Answer 1

Option 1: There is tax liability on both income earned and interest earned. Taxable income-$4,000 Income after tax - Taxable income x (1 - tax rate) $4,000 x (1-0.30) = $4,000 x 0.70 = $2,800 This amount is invested in a savings account, which earns 10% interest. Interest amount after tax-income after tax x Rate of interest x (1-tax rate) $2,800 10% $280 x 0.70 = ș196 (1-0.30) Required value Income after tax + Interest amount after tax 2,800 196 = $2.996 (Answer) Option 2 There is no tax liability on any amount of savings. The tax is only applicable if the total amount is withdrawn for investment purpose. Income Saved = $4,000 This amount is invested in a retirement account, which earns 10% interest. Interest amount = Income saved x Rate of interest $4,000 × 10% $400