Q:
Dennis, a resident of Pennsylvania, bought a U.S. Treasury Bond which pays 7% interest annually (coupon rate).  His federal income tax rate is 30% and State of Pennsylvania tax rate is 6%.  What would be his after-tax yield?
a) 5.5%
b) 5.2%
c) 6.2%
d) 4.9%
A:

The correct answer is d)
The interest from U.S. Treasury Bonds is exempt from state and local taxes, however; it is subject to federal taxes.  When deciding to invest in a taxable versus a non-taxable investment, you must compute the tax-exempt yield. 
To do this you take the taxable-equivalent yield multiplied by (1-Marginal tax rate) which equals the tax-exempt yield.  [0.07 x (1- 0.30) = .049 or 4.9%]. 
A tax-exempt investment is only more attractive if it yields higher than 4.9%.


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