Juan, was considering purchasing an interest in a tax-exempt bond fund for $100,000, when he discovered that the interest must be included on his state income tax return. The interest rate is 5%. His marginal Federal tax rate is 35%, and his marginal
state income tax rate is 10%. Juan itemizes his deductions on his Federal income tax return. As an alternative, Juan can purchase a state bond (a "double-exempt bond") yielding 4.9% interest that is exempt from both Federal and state income tax. Which investment would yield the greater after-tax return?
Juan will receive $5,000 before-tax from the bond fund. The state income tax is $500 [(.10)($5,000)]. The state income tax will be deductible on the Federal return; thus, the state taxes will reduce Juan's after-tax income by only $325 [(1 – .35)($500]. Therefore, the annual after-tax return is $4,675 ($5,000 – $325), or 4.675%. The double-exempt bonds will yield 4.9% after tax; therefore, it is the preferred investment, assuming equal risks.
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