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Video instructions and help with filling out and completing How to report acquisition premium on tax exempt bonds
Comparing tax-exempt bonds with taxable bonds investors should always compare the after tax returns provided by each bond to compare tax-exempt bonds with non taxable bonds one must compute the actual after tax returns considering all taxes on the income and earned and realized capital gains to solve for the after tax rate of return we use a simple formula we use R to represent the before tax rate of return on the taxable bond and let T represent the combined tax rate for both federal and local taxes to compute the after tax returns on a taxable secured bond we use the formula R times 1 minus T we then compare the after-tax return to the taxes of security the investor will be better off holding whatever security provides the higher return knowledge try an example suppose your tax bracket is 35 percent would you prefer to earn a 6% taxable return or a 4% non-taxable return although we need to do is solve for the after-tax return of the taxable security we do this by using the formula that you learned in this lesson if we plug in our figures we find the after-tax return is 3.9 percent 6 times 1 minus 0.35 or equals 3.9 percent which is less than the four percent return provided by the tax exempt investment this means that we should invest our money and the tax-exempt security even though the explicit return is lower than the explicit return of the taxable investment another way to compare taxable bonds with non taxable bonds to find the equivalent taxable return well a R represent the before tax return offered by the taxable bond T represents the combined federal and local taxes that the return on taxable bond is subject to and our M represent the return offered on the taxes of municipal bond to find the equivalent tax for return our formula is R equals R M over 1 minus T thus it is simply the taxable yield divided by 1 minus T the equivalent taxable return increases with higher marginal tax rates therefore tax exempt municipal bonds are more attractive to individuals and higher tax records if tax-exempt municipal bonds are available at 4 percent and our tax bracket is 35 percent then we simply plug in our values to find the equivalent tax for return we find that the equivalent taxable return at 35 percent tax bracket for a 4% non-taxable bond is 6 point one five percent therefore a taxable bond that yields six point one five percent would be equivalent to a tax-exempt bond that yields four percent for a person and a 35 percent tax bracket for a taxable bond to be a better investment than a tax-exempt bond and must offer it they before tax yield of six point one five percent we can also use a formula to calculate the cut off tax bracket the formula is 1 minus R M over R the yield ratio.