What Is an After-Tax Basis?
- After-tax bases compare the net after-tax returns on both taxable and tax-exempt bonds to gauge which has a higher yield.
- The after-tax basis calculation allows investors to make informed decisions to maximize their portfolio's return.
- Most corporate bonds may state a higher yield than other tax-exempt bonds since the investors have to take on additional risk.
Understanding After-Tax Bases
Taxable bonds, such as corporate bonds, may offer higher returns than tax-exempt bonds, such as municipal bonds. Calculating the after-tax basis will allow an investor to make a better decision that will maximize their portfolio's return.
Most corporate bonds may state a higher yield than their tax-exempt cousins, given that the investor has to take on additional risk. While an investor might be willing to take on that added risk, they will want to ensure that the after-tax basis is higher than, say, a comparable municipal bond. To compare the return on investment (ROI) of the two products accurately they must first calculate the amount of tax on the corporate bond earnings stream. Taxes are deducted from earnings to give the actual yield. Then, and only then, can an investor 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 lies in the different methodologies that are used when calculating the tax on corporate bonds. Generally speaking:
- All corporate bonds will be taxed, both at the state and federal level, based on the interest earnings.
- 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 Bases
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 much safer investment vehicle. 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 creditworthy 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.