NASAA Series 66 Uniform Combined State Law ExaminationClient Investment Recommendations and StrategiesMedium
A client is considering the purchase of a municipal bond with a coupon rate of 4.5% and a par value of $1,000. They are in the 32% federal tax bracket and their state's highest marginal income tax rate is 5%. Assuming the bond is exempt from both federal and state taxes for this client, what is the bond's tax-equivalent yield (TEY)?
- A7.50%
- B6.72%
- C4.50%
- D5.63%
Show answer & explanationAnswer & explanation
Correct answer: B. 6.72%
The tax-equivalent yield (TEY) is calculated using the formula: Tax-Exempt Yield / (1 - Marginal Tax Rate). In this case, the combined marginal tax rate is 32% + 5% = 37%. So, 4.5% / (1 - 0.37) = 4.5% / 0.63 = 0.071428 or 7.14%. The closest answer is C.
Why the other options are wrong
- A. This would imply a much higher effective tax rate (4.5% / (1 - X) = 7.5% => 1 - X = 0.6 => X = 40%).
- C. This is the nominal yield, not the tax-equivalent yield.
- D. This calculation only considers the federal tax rate (4.5% / (1-0.32) = 6.62%).
Tax-Equivalent Yield (TEY)
The yield a taxable bond would need to offer to provide the same after-tax return as a tax-exempt bond.
- Formula: Tax-Exempt Yield / (1 - Marginal Tax Rate)
- Used to compare taxable and tax-exempt investments.
- Marginal tax rate includes federal and, if applicable, state and local taxes.
- Higher for investors in higher tax brackets.
Memory trick: TEY: your tax-free gain, divided by one minus the tax pain.