An investor residing in California is subject to a 35\% federal marginal income tax rate a… — FINRA SIE (Securities Industry Essentials)

An investor residing in California is subject to a $35\%$ federal marginal income tax rate and an $8\%$ state marginal income tax rate. The investor is comparing two fixed-income instruments with identical credit ratings and maturities: an out-of-state municipal general obligation bond yielding $4.20\%$ and an in-state corporate debenture yielding $6.50\%$ . Assuming no federal tax deductibility for state taxes, which of the following correctly compares the after-tax yields of these two investments for the investor?

The out-of-state municipal bond provides a higher after-tax yield of $3.864\%$ , compared to $3.705\%$ for the corporate debenture.Answer
B
The out-of-state municipal bond provides a higher after-tax yield of $4.200\%$ , because municipal bond interest is exempt from both federal and state taxes regardless of the issuer's location.
C
The corporate debenture provides a higher after-tax yield of $4.225\%$ , because corporate bond interest is subject only to federal income tax.
D
The corporate debenture provides a higher after-tax yield of $3.705\%$ , compared to $2.730\%$ for the out-of-state municipal bond.

Answer

The out-of-state municipal bond provides a higher after-tax yield of

3.864\%

, compared to

3.705\%

for the corporate debenture.

Interest earned on municipal bonds is exempt from federal income tax. However, out-of-state municipal bonds are subject to state income taxation in the investor's home state. Multiplying the

4.20\%

yield by

(1 - 0.08)

yields an after-tax return of

3.864\%

. Corporate bonds are subject to both federal and state income taxes. Multiplying the

6.50\%

coupon by

(1 - (0.35 + 0.08))

results in an after-tax return of

3.705\%

. Thus, the out-of-state municipal bond yields more after taxes.

Step-by-Step Solution

Calculate the after-tax yield of the out-of-state municipal bond.

After-tax yield =

4.20\% \times (1 - 0.08) = 3.864\%

Municipal bond interest is federally tax-exempt. However, because it is issued by an out-of-state entity, it is subject to the investor's state income tax of

8\%

Calculate the combined tax rate and after-tax yield of the corporate debenture.

Combined tax rate =

35\% + 8\% = 43\%

. After-tax yield =

6.50\% \times (1 - 0.43) = 3.705\%

Corporate bond interest is fully taxable at both the federal (

35\%

) and state (

8\%

) levels.

Compare the after-tax yields of both instruments.

The out-of-state municipal bond (

3.864\%

) yields more after taxes than the corporate debenture (

3.705\%

Comparing

3.864\%

3.705\%

demonstrates that the out-of-state municipal bond offers a higher net yield.

Key Concept

Tax Treatment of Municipal vs. Corporate Bonds

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