What is After-Tax Basis
After-tax basis refers to how one compares net yields on taxable and tax-exempt bonds. Taxable bonds, such as corporate bonds, may offer higher returns than tax-exempt bonds. Municipal bonds are a typical example of tax-exempt bonds.
The after-tax basis is a method of comparison useful in comparing bonds before investing.
BREAKING DOWN After-Tax Basis
Taxable bonds may state a higher yield than their tax-exempt cousins, but investors want to compare the return on investment of the two products accurately. To do this, they must first calculate the amount of tax on the corporate bond. Taxes are deducted from earnings to give the actual yield. Once found, the investor can compare the returns of the taxable bond and the tax-exempt bond.
Depending on the circumstances of the bond’s redemption, calculating how much a bondholder will pay in tax may require the assistance of a financial or tax professional. An after-tax basis comparison can be tricky to figure. This difficulty is because the taxing of corporate bonds varies.
- All corporate bonds will be taxed based on the interest earnings. Interest is subject to both state and federal taxes.
- If redemption happens before maturity, the profits may be subject to capital gains tax.
- Some bonds do not pay interest on coupons but are merely redeemable for their face value at maturity. Investors purchase no-coupon bonds at a discount and the difference between the bond’s purchase price and its redemption value at maturity is subject to taxes.
Considerations Besides After-Tax Costs
Calculating the after-tax yield on a corporate bond can allow you to compare it to the return on a tax-exempt bond. However, that comparison does not take into account all of the factors that determine whether a taxable or a tax-exempt bond is a better investment.
For example, many people opt for municipal bonds because they have an extremely low default risk, which makes them a very safe investment. Corporate bonds, on the other hand, may come with a higher degree of risk. Some may offer very high yields, but that higher yield likely correlates directly to a higher risk.
Credit rating agencies such as Moody’s can provide potential investors with information about how credit-worthy a company is and what an investor can expect. Some corporate bonds are also callable, meaning that the issuing company can call away the obligations for redemption before they mature. Investors receive a predetermined amount based on when the bonds are called, but must then go into the open marketplace to reinvest these funds. Often they will not be able to get the same returns as the original investment provided.