An investors who pay higher taxes may want to consider investing in tax-free mun

Question

An investors who pay higher taxes may want to consider investing in tax-free municipal bonds or equivalent investments. The higher tax bracket an individual is in, the more appealing a tax-free investment would become. The equivalent yield formula below can be used to compare the yield on the tax-free investment versus an investment that is taxed. Suppose an investor purchased a tax-free city bond paying 5%. What is the equivalent yield on a taxable corporate bond at a marginal tax rate of 30%? Tax equivalence = Tax-free yield/(1 - marginal tax free)

Explanation / Answer

Solution:

Tax equivalence = Tax - free yield / ( 1 - marginal tax rate ) Tax free yield = 5% Marginal tax rate = 30% Tax equivalence = 5 % / ( 1 - 30 %) 7.14% Tax equivalence = 7.14%

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