Investment Securities - Tax Implications

Tax Equivalent Yield
Because municipal bonds have at least one tax-free component - they are free of federal tax - you will need to know how to calculate the tax equivalent yield (TEY). This yield describes the interest rate that one would need to earn with a taxable bond issue to equal the tax advantages of a municipal bond. The equation is simple:
 

After-tax Yield =     Muni Bond Yield
                                           (100% - customer's tax bracket rate)

For example, let's say Stanley Lehman, MD, is a high-income client of yours. He tells you that he earns a lot of money and is in the 35% tax bracket. You confirm his annual salary at $300,000 a year. Right now, 20-year munis are paying 4.8%. If Dr. Lehman is in the 35% tax bracket, the tax-equivalent yield (TEY) would be calculated as follows:

.048 = .048 = 7.38%
100-35 .65

 

If you were to compare the muni bond yielding 4.8% with a similar quality corporate bond that corporate bond would have to yield at least 7.38% to be considered as an investment option. If the corporate bond yields more than 7.38% the corporate bond would be a better investment.

Corporate Securities: Common Stock


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