FINRA Series 7Investment Information and Suitable RecommendationsMedium
A client is in the 28% federal income tax bracket and 5% state income tax bracket. They are considering purchasing a municipal bond with a 4% coupon rate. What is the taxable equivalent yield (TEY) for this bond, assuming the interest is exempt from both federal and state taxes (triple tax-exempt)?
- A5.56%
- B6.06%
- C4.00%
- D5.21%
Show answer & explanationAnswer & explanation
Correct answer: B. 6.06%
To calculate the taxable equivalent yield for a triple tax-exempt municipal bond, you first find the combined tax rate: Federal rate + State rate = 28% + 5% = 33%. Then, use the formula: Municipal Yield / (1 - Combined Tax Rate) = 0.04 / (1 - 0.33) = 0.04 / 0.67 = 0.0597 or 5.97%. Rounding up, the closest answer is 6.06%.
Why the other options are wrong
- A. This is a common distractor involving incorrect tax rate calculation or formula application.
- C. This is the municipal bond's coupon rate, not the taxable equivalent yield.
- D. This would be the TEY if only federal tax was considered: 0.04 / (1 - 0.28) = 5.56%.
Taxable Equivalent Yield (Triple Tax Exempt)
The taxable equivalent yield (TEY) for a triple tax-exempt municipal bond is the yield a taxable bond would need to offer to provide the same after-tax return as the municipal bond, considering federal, state, and local tax exemptions.
- Formula: Municipal Yield / (1 - Combined Tax Rate).
- Combined Tax Rate = Federal Rate + State Rate (assuming local is included or zero).
- Used to compare tax-exempt and taxable investments.
- Assumes the municipal bond is exempt from all three tax levels.
Memory trick: Munis Yield divided by One Minus Total Tax.