Not all types of income are taxed at the same rate; income from certain investments is taxed at a preferential rate. Thus, when comparing investments, it’s important to consider the after-tax return of the investment instead of simply looking at the before-tax return.
The after-tax return is calculated as follows:
after-tax return = before-tax return x (1 – marginal tax rate)
For example, let’s consider a corporate bond that pays 6% interest and a tax-exempt municipal bond that pays 4% interest. If the interest income from the corporate bond is taxed at a rate of 35%, then the after-tax return of the corporate bond is just 3.9%. Think about this way: if you invested $100 in the corporate bond you would receive $6 of interest annually, but that $6 of income would be taxed at a rate of 35%, resulting in taxes of $2.10 ($6 x 35%). Thus, you received $6 of interest but after paying taxes on that income you were left with just $3.90. The municipal bond, on the other hand, is tax-exempt which means the tax rate on interest earned from the municipal bond is zero. Thus, if you invested $100 in the municipal bond you would receive just $4 of interest but you would get to keep the entire $4 (since the tax rate is 0%). Thus, the municipal bond would have a higher after-tax rate of return even though the corporate bond would have a higher before-tax rate of return.
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