A municipal bond is yielding 7% and a similar-risk corporate bond is yielding 10%. If you are in the 35% marginal tax bracket, which investment is a better choice for you?

Question

Quizplus · Accepted Answer

In this scenario, the municipal bond yields 7% but is tax-free, while the corporate bond yields 10% but is not tax-free. As the investor is in the 35% marginal tax bracket, their after-tax return from the corporate bond is only 6.5% (i.e. 10%*(1-0.35)). On the other hand, the municipal bond's tax-free yield of 7% is equivalent to a taxable yield of 7/(1-0.35) = 10.77%. Therefore, the municipal bond is the better choice as it offers a higher after-tax return (10.77% > 6.5%). Since the investor is in the 35% marginal tax bracket, they would need to pay taxes on the interest earned from the corporate bond. At a 10% yield, the after-tax yield would be 6.5%. However, since the municipal bond is tax-free, the investor would receive the full 7% yield. Therefore, the municipal bond is the better choice, as it has a higher after-tax yield than the corporate bond.

A Municipal Bond Is Yielding 7% and a Similar-Risk Corporate