SIE practice questionhardMunicipal Bonds — Taxable Equivalent Yield
An investor in the 32% federal tax bracket is considering a municipal bond yielding 4%. What is the taxable equivalent yield?
- A6.25%
- B5.26%
- C4.00%
- D5.88%✓ Correct answer
Explanation
Why D — 5.88%
Taxable equivalent yield = tax-free yield / (1 - tax rate) = 4% / (1 - 0.32) = 4% / 0.68 = 5.88%. This means a taxable bond would need to yield 5.88% to provide the same after-tax return as a 4% municipal bond for someone in the 32% bracket. Higher tax brackets benefit more from tax-exempt municipal bond income.
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