FINRA Series 7Investment Information and Suitable RecommendationsMedium
A client is in the 32% federal income tax bracket and 7% state income tax bracket. They are considering a municipal bond with a 3.8% coupon rate. What is the taxable equivalent yield?
- A3.80%
- B6.23%
- C5.59%
- D5.00%
Show answer & explanationAnswer & explanation
Correct answer: B. 6.23%
First, calculate the combined tax rate: 32% (federal) + 7% (state) = 39%. Then, apply the taxable equivalent yield formula: Municipal Yield / (1 - Combined Tax Rate) = 0.038 / (1 - 0.39) = 0.038 / 0.61 = 0.06229 or 6.23%.
Why the other options are wrong
- A. This is the municipal bond's coupon rate, not the taxable equivalent yield.
- C. This would be the result if only federal tax was considered (3.8% / (1-0.32) = 5.59%).
- D. This would be the result if only federal tax was considered (3.8% / (1-0.32) = 5.59%).
Taxable Equivalent Yield (TEY)
The yield a taxable bond must offer to match the after-tax return of a tax-exempt municipal bond, considering both federal and state income taxes.
- Compares tax-exempt municipal bond returns to taxable investments.
- Accounts for both federal and state income tax rates.
- Formula: Municipal Yield / (1 - Combined Tax Rate).
Memory trick: Tax-Free Muni, Taxable Equivalent - What's the 'real' gain?