Question

Matt wants to invest 100,000 in preferred stock that will pay qualified dividend income of 7%.

Matt has the following personal and business debt:

- Personal credit card with annual interest rate of 12%: $10,000

- Business credit card with annual interest rate of 9.5%: $50,000

- Home mortgage with annual interest rate of 6%: $450,000

- Student loans with annual interest rate of 7.5%: %40,000

- Car loan with annual interest rate of 8%: 20,000

Matt's marginal tax rate is 32% with dividends being taxed at 15%. How should Matt allocate the $100,000 to obtain the highest after-tax return?

Answer 1

In this question we have to arrange the possible allocation options in descending order with the option giving highest return on top. In case of debt, the marginal cost saved after taxes by opting to repay debt instead of its servicing will be considered as return as money saved is money earned.

Option	Return calculation	Return
Preferred stock	7*(1-.15)	5.95%
Personal credit card	interest not tax deductible expense	12%
Business credit card	9.5*(1-.32)	6.46%
Home Mortgage	interest not tax deductible expense	6%
Student loans	interest not tax deductible expense	7.5%
Car loan	8*(1-.32)	5.44

Note: (a.) Assuming student and home mortgage loans are not tax deductibles, had they, then appropriate tax benefits would be taken. (b.) Assuming car loan is taken for business vehicle, hadn't that, then tax benefits wouldn't be taken.

RANK	After tax return	Maximum amount
I	Personal credit card	10,000
II	Student loans	40,000
III	Business credit card	50,000
IV	Home mortgage	450,000
V	Preferred stock	100,000
VI	Car loan	20,000

So with Matt having $100,000 at his disposal, he should repay $10,000 of personal credit card outstanding amount, $40,000 ofstudents loan amount and $50,000 of business credit card outstanding amount. This will give him highest after-tax return.