FINRA Series 7Investment Information and Suitable RecommendationsHard
A client in the 28% federal income tax bracket and 5% state income tax bracket is considering a municipal bond yielding 3.5%. What is the taxable equivalent yield for a corporate bond, assuming both federal and state taxes apply?
- A5.38%
- B5.65%
- C4.86%
- D5.22%
Show answer & explanationAnswer & explanation
Correct answer: D. 5.22%
To find the taxable equivalent yield when both federal and state taxes apply, you must first combine the federal and state tax rates to get the total tax rate, then use the formula: Municipal Yield / (1 - Total Tax Rate).
Why the other options are wrong
- A. This might result from an incorrect combination of tax rates or a calculation error.
- B. This is incorrect. It would imply a lower effective tax rate or a higher municipal yield.
- C. This calculation would be incorrect if only federal or only state taxes were considered separately.
Taxable Equivalent Yield (Combined Tax)
The taxable equivalent yield for a municipal bond, considering both federal and state taxes, is calculated by dividing the municipal yield by (1 - combined federal and state tax rate).
- Municipal bond interest is generally exempt from federal income tax.
- It may also be exempt from state and local taxes if issued in the resident's state.
- Used to compare tax-exempt municipal bonds with taxable corporate bonds.
Memory trick: TEY helps you see if a tax-free apple is better than a taxable orange, especially when you're paying both federal and state taxes.