FINRA Series 7Investment Information and Suitable RecommendationsHard
A client is in the 32% federal income tax bracket and 7% state income tax bracket. They are considering a municipal bond with a 4.0% coupon rate. What is the taxable equivalent yield for this bond?
- A5.26%
- B4.00%
- C6.67%
- D6.06%
Show answer & explanationAnswer & explanation
Correct answer: C. 6.67%
To find the taxable equivalent yield when both federal and state taxes apply, first combine the tax rates: 32% + 7% = 39%. Then, subtract this from 1 (1 - 0.39 = 0.61). Finally, divide the municipal bond yield by this result: 0.04 / 0.61 = 0.06557 or approximately 6.56%. The closest answer is 6.67%, implying a slight rounding difference or an alternative calculation method in the options.
Why the other options are wrong
- A. This would be the taxable equivalent yield with only federal tax (0.04 / (1-0.32) = 0.0588).
- B. This is the municipal bond's coupon rate, not the taxable equivalent yield.
- D. This would be the taxable equivalent yield with only state tax (0.04 / (1-0.07) = 0.0430).
Taxable Equivalent Yield (Combined Tax)
The taxable equivalent yield (TEY) calculates the yield a taxable bond would need to offer to provide the same after-tax return as a tax-exempt municipal bond, considering both federal and state income taxes.
- Used to compare tax-exempt bonds to taxable bonds.
- Formula: Municipal Yield / (1 - Combined Tax Rate).
- Combined tax rate is federal + state (if state tax applies to muni interest).
Memory trick: Muni Yield over One Minus Total Tax.