Tax Implications

Lesson

In this sub-section, we will discuss the tax implications of fixed-income securities. Understanding the tax implications is crucial for investors as it directly impacts their returns.

Practice Question #1

Which of the following is NOT a tax implication of fixed income securities?

A) Interest income

B) Capital gains tax

C) Dividends

D) Tax-equivalent yield

Select an option above to see an explanation here.

A) Interest income is a tax implication of fixed-income securities. B) Capital gains tax is a tax implication of fixed-income securities. C) Dividends are a tax implication of equity securities, not fixed-income securities. D) Tax-equivalent yield is a tax implication of fixed-income securities.

Terms

Taxable income:: The portion of an individual's or entity's income subject to taxation.
Tax-exempt income:: Income that is not subject to federal income tax.

Practice Question #2

What is the tax-equivalent yield of a municipal bond with a 2.5% yield for an investor in the 22% tax bracket?

A) 2.05%

B) 3.21%

C) 0.0385

D) 0.0412

Select an option above to see an explanation here.

A) 2.05% is lower than the actual yield of the municipal bond. B) The tax-equivalent yield is calculated as 2.5% / (1 - 0.22) = 3.21%. C) 3.85% is too high for the tax-equivalent yield. D) 4.12% is too high for the tax-equivalent yield.

Historical Example

In the early 1980s, the U.S. government introduced tax reform that significantly changed the tax implications of fixed-income securities. The reform lowered tax rates and simplified the tax code, shifting investor preferences from tax-exempt municipal bonds to taxable bonds with higher yields.

Practice Question #3

Which of the following is true about Treasury bonds?

A) They are subject to federal, state, and local taxes.

B) They are exempt from federal taxes but subject to state and local taxes.

C) They are subject to federal taxes but exempt from state and local taxes.

D) They are exempt from all taxes.

Select an option above to see an explanation here.

A) Treasury bonds are not subject to state and local taxes. B) Treasury bonds are subject to federal taxes. C) Treasury bonds are subject to federal taxes but exempt from state and local taxes. D) Treasury bonds are not exempt from all taxes.

Real-World Example

An investor in the 24% tax bracket is considering investing in a municipal bond with a 3% yield or a corporate bond with a 4% yield. To compare the two investments, the investor calculates the tax-equivalent yield of the municipal bond: 3% / (1 - 0.24) = 3.95%. Since the tax-equivalent yield of the municipal bond is lower than the corporate bond's yield, the investor chooses the corporate bond for a higher after-tax return.