A client is in the 28% federal income tax bracket and 5% state income tax bracket. They are comparing a municipal bond yielding 4.2% (tax-exempt at federal level, taxable at state level) to a corporate bond yielding 6.0%. What is the Taxable Equivalent Yield (TEY) for the municipal bond for this client?

Correct answer: B. 5.83%

First, calculate the after-tax yield of the municipal bond: 4.2% * (1 - 0.05 state tax) = 4.2% * 0.95 = 3.99%. Then, use this after-tax yield to find the TEY with the federal tax rate: TEY = After-Tax Yield / (1 - Federal Tax Rate) = 3.99% / (1 - 0.28) = 3.99% / 0.72 = 5.54%. The closest answer is 5.83%, implying a slightly different calculation method for combined tax rates or rounding. Let's re-evaluate total tax first then apply. The federal tax rate is 28%, and the state tax rate is 5%. The municipal bond is federal tax-exempt but state taxable. So the effective tax rate on the muni is only the state tax rate of 5%. The after-tax yield of the muni is 4.2% * (1 - 0.05) = 3.99%. Now, to find the TEY that a corporate bond (fully taxable at both federal and state) would need to match this after-tax yield, we need to consider both federal and state taxes for the corporate bond. The combined tax rate for a fully taxable bond is 28% + 5% = 33%. TEY = Municipal Yield / (1 - Combined Tax Rate). Wait, this is for a fully tax-exempt muni. If the muni is only federal exempt, but state taxable, then the calculation changes. The after-tax yield of the municipal bond is 4.2% * (1 - 0.05) = 3.99%. Now, to compare this to a corporate bond, we need to find what nominal yield a corporate bond would need to have to result in a 3.99% after-tax yield, considering both federal and state taxes. The combined tax rate for the corporate bond is 28% (federal) + 5% (state) = 33%. So, TEY = 3.99% / (1 - 0.33) = 3.99% / 0.67 = 5.955%. Let's re-examine the options and typical exam approaches. Often, if a municipal bond is only federal exempt, the TEY calculation uses only the federal rate to compare it to a fully taxable bond. In this case, TEY = 4.2% / (1 - 0.28) = 4.2% / 0.72 = 5.833%. This matches option A. This approach simplifies by assuming the state tax on the municipal bond is implicitly handled by comparing it to a corporate bond that would also be subject to state tax, and the TEY specifically focuses on the federal exemption benefit. It's a common simplification in Series 7 TEY questions when state taxability differs. The exact after-tax yield of the municipal bond is 4.2% * (1 - 0.05) = 3.99%. The corporate bond's after-tax yield would be 6.0% * (1 - 0.28 - 0.05) = 6.0% * 0.67 = 4.02%. So the corporate bond has a better after-tax yield. However, the question asks for the TEY of the municipal bond. The conventional TEY formula for a municipal bond that is federally exempt is: Municipal Yield / (1 - Federal Tax Rate). TEY = 4.2% / (1 - 0.28) = 4.2% / 0.72 = 5.833%. This is the most common way it's asked and calculated on the exam. The state tax on the muni makes it less attractive than a fully triple tax-exempt, but for TEY, the federal exemption is the primary focus. Thus, a corporate bond would need to yield 5.83% to equal the *federal tax-exempt portion* of the municipal bond's yield. The question's complexity lies in the state tax treatment of the muni. If the muni is federal tax-exempt and state taxable, the effective 'tax-free' yield for federal purposes is still 4.2%. So, TEY = 4.2% / (1 - 0.28) = 5.83%. This is the standard exam calculation for TEY when only federal exemption is given or implied as the primary benefit for the TEY calculation. The state tax on the muni simply reduces its *actual* after-tax yield, but TEY focuses on the equivalent gross yield for a *fully taxable* bond to match the *federally tax-free portion* of the muni's yield. Thus, 5.83% is the correct interpretation based on typical Series 7 TEY questions.