FINRA Series 7Investment Information and Suitable RecommendationsMedium
A client in the 28% federal income tax bracket and 5% state income tax bracket is considering a municipal bond yielding 4.5% and a corporate bond yielding 6.0%. Which bond offers a better after-tax return for this client?
- AThe corporate bond, as its after-tax yield is 4.38%
- BThe municipal bond, as its after-tax yield is 4.05%
- CThe municipal bond, as its after-tax yield is 4.5%
- DThe corporate bond, as its after-tax yield is 3.90%
Show answer & explanationAnswer & explanation
Correct answer: C. The municipal bond, as its after-tax yield is 4.5%
Municipal bond interest is exempt from federal income tax and often from state and local taxes if the bond is issued in the investor's state. Therefore, the municipal bond's 4.5% yield is its after-tax yield. For the corporate bond, the combined tax rate is 28% + 5% = 33%. The corporate bond's after-tax yield is 6.0% * (1 - 0.33) = 6.0% * 0.67 = 4.02%. The municipal bond offers a higher after-tax return (4.5% vs 4.02%).
Why the other options are wrong
- A. This calculation for the corporate bond's after-tax yield is incorrect. It should be 6.0% * (1 - 0.33) = 4.02%.
- B. This suggests a state tax on the municipal bond, which is not typically applied if issued in-state. Even if it were, the calculation is incorrect.
- D. This calculation for the corporate bond's after-tax yield is incorrect. It should be 6.0% * (1 - 0.33) = 4.02%.
Taxable Equivalent Yield (Combined Tax)
The yield a taxable bond must offer to provide the same after-tax return as a tax-exempt municipal bond, considering both federal and state income taxes.
- Municipal bond interest is generally federal tax-exempt.
- Municipal bond interest may also be state and local tax-exempt if issued in the investor's state of residence.
- Corporate bond interest is subject to both federal and state income taxes.
Memory trick: Tax-free munis often win after-tax.