Tom can choose when he is to receive $100,000 of fully taxable bonus. If he rece

Question

Tom can choose when he is to receive $100,000 of fully taxable bonus. If he receives the bonus at the end of 2016, his bonus will be $100,000. If he postpones receipt of the bonus until the end of 2017, the amount will be $110,000. If Tom receives the bonus at the end of 2016, he can invest the proceeds with a pre-tax return of 10% over the next year.

If the marginal tax rate of Tom is 31% in 2016 and 2017, when should he elect to receive the bonus?

At what pre-tax rate of return will Tom be indifferent to receiving the bonus in the alternative years?

If the marginal tax rate of Tom increases to 35% in 2017, when should he elect to receive the bonus?

What would the tax rate need to be in 2017 to make Tom indifferent to the two options?

Explanation / Answer

1. To decide when to receive bonus

Tom should elect to receive bonus in 2017

2.Pre-tax rate of return

Amount of bonus received if elected to received in 2017 = 75,900

Amount of bonus received if elected to received in 2016 = 69,000

Difference in amount = 6,900

Amount of bonus to be reinvested to earn post tax return of 6,900 = 69,000

Post tax return rate = 6,900/69,000*100 = 10%

Pre tax return - 31%* Pre tax return = 6,900

Pre tax retuen = 10,000

Pre tax return rate = 10,000/69,000*100= 14.49%

3. To decide when to receive bonus

Tom should elect to receive bonus in 2016

4. Tax rate in 2017

Let tax rate be x%

69,000+(6,900 - x% *6,900) = 110,000- x% *110,000

x% *110,000 - x% *6,900 = 110,000-69,000-6,900

103,100 *x% = 34,100

x% =34,100/103,100

x=33.07%

tax rate in 2017 = 33.07%

Particulars 2016 2017 Bonus received 100,000 110,000 Less: Tax @ 31% 31,000 34,100 Post tax amount received (A) 69,000 75,900 Proceeds of 2016 reinvested @10% 6,900 0 Tax on amount reinvested @ 31% 2,139 0 Post tax amount received from reinvestment (B) 4,761 0 Total cash receipts (A+B) 73,761 75,900

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