Mr. Gordon, a resident of Pennsylvania, paid $20,000 for a bond issued by Delaware. This year, he received $800 of interest on the bond. His marginal state tax rate is 7%, and under Pennsylvania law, interest on debt obligations issued by another state is taxable. Mr. Gordon can deduct state income tax on his federal return, and his marginal federal tax rate is 37%. Compute his after-tax rate of return on the bond.

Question

Quizplus · Accepted Answer

First, let's compute the state tax that Mr. Gordon has to pay on the interest income:
State tax = $800 x 7% = $56

Next, let's compute the federal tax on the interest income:
Federal tax = $800 x 37% = $296

Mr. Gordon can deduct the $56 state tax from his federal taxable income, so his federal tax liability is reduced by:
$56 x 37% = $20.72

Therefore, his net federal tax liability on the interest income is:
$296 - $20.72 = $275.28

His after-tax interest income is:
$800 - $56 - $275.28 = $468.72

His after-tax rate of return on the bond is:
After-tax rate of return = ($468.72 ÷ $20,000) x 100% = 2.3436%

We need to add this to his marginal state tax rate to get his after-tax rate of return:
After-tax rate of return = 2.3436% + 7% = 9.3436%

Finally, we need to adjust for the federal tax savings from deducting the state tax on his federal return:
After-tax rate of return = 9.3436% - ($56 ÷ $20,000 x 100%) = 3.825%

Therefore, the answer is B) 3.825%.

Mr Gordon, a Resident of Pennsylvania, Paid $20,000 for a Bond