Introduction
In preparing for the FINRA Series 7 exam, understanding how to calculate the taxable equivalent yield of municipal bonds is essential. This financial measure helps investors evaluate the benefit of tax-exempt income from municipal bonds compared to taxable securities. Through this article, you’ll learn to solve a typical question on this topic using step-by-step calculations and engage with quizzes to reinforce your understanding.
Understanding Taxable Equivalent Yield
Taxable equivalent yield (TEY) allows investors to compare tax-exempt and taxable investments effectively. When a municipal bond offers a tax-free interest rate, converting this to an equivalent taxable yield lets investors see the potential benefit. The formula to calculate TEY is:
$$ \text{TEY} = \frac{\text{Tax-Free Municipal Yield}}{1 - \text{Marginal Tax Rate}} $$
Example Scenario
Consider this practice question:
A client is interested in investing in a municipal bond with a 4% nominal yield. The client is in the 32% federal tax bracket. What is the taxable equivalent yield?
To solve:
- Identify Municipal Yield: 4%
- Identify Tax Bracket: 32% or 0.32 as a decimal
- Apply the TEY Formula:
$$
\text{TEY} = \frac{4\%}{1 - 0.32} = \frac{4\%}{0.68} = 5.88\%
$$
Therefore, the taxable equivalent yield is 5.88%.
Conclusion
Understanding how to calculate taxable equivalent yield is a valuable skill for the Series 7 exam and real-world financial advising. It enables potential investors to make informed decisions about their investment portfolios. By practicing with example questions and engaging in quizzes, you reinforce this knowledge.
Glossary
- Nominal Yield: The interest rate stated on the bond.
- Tax-Exempt: Income free from federal taxation.
- Marginal Tax Rate: The percentage applied to your last dollar of income.
Additional Resources
Interactive Quizzes
Challenge yourself with these practice questions to solidify your knowledge:
### What is the taxable equivalent yield if a municipal bond offers a 3% yield and the investor's tax rate is 28%?
- [ ] 2.16%
- [x] 4.17%
- [ ] 5.12%
- [ ] 4.56%
> **Explanation:** TEY = \\( \frac{3\%}{1 - 0.28} = \frac{3\%}{0.72} = 4.17\%\\). A 3% tax-free yield is equivalent to a 4.17% taxable yield when the tax rate is 28%.
### Given a tax-exempt yield of 5% and a tax bracket of 25%, calculate the taxable equivalent yield.
- [x] 6.67%
- [ ] 5.00%
- [ ] 7.50%
- [ ] 8.00%
> **Explanation:** TEY = \\( \frac{5\%}{1 - 0.25} = \frac{5\%}{0.75} = 6.67\%\\).
### An investor in the 35% tax bracket receives a 4.5% yield on a municipal bond. What is the taxable equivalent yield?
- [ ] 4.50%
- [ ] 6.50%
- [x] 6.92%
- [ ] 7.30%
> **Explanation:** TEY = \\( \frac{4.5\%}{1 - 0.35} = \frac{4.5\%}{0.65} = 6.92\%\\).
### What is the taxable equivalent yield of a municipal bond yielding 6%, if the investor's tax rate is 30%?
- [ ] 8.00%
- [ ] 7.14%
- [x] 8.57%
- [ ] 9.42%
> **Explanation:** TEY = \\( \frac{6\%}{1 - 0.30} = \frac{6\%}{0.70} = 8.57\%\\).
### With a 28% tax rate, calculate the taxable equivalent yield of a 2.5% municipal bond.
- [ ] 3.25%
- [x] 3.47%
- [x] 3.47%
- [ ] 3.50%
> **Explanation:** TEY = \\( \frac{2.5\%}{1 - 0.28} = \frac{2.5\%}{0.72} = 3.47\%\\).
### Determine the TEY for a 3.5% municipal bond with a 20% tax rate.
- [ ] 4.25%
- [ ] 4.00%
- [ ] 3.85%
- [x] 4.38%
> **Explanation:** TEY = \\( \frac{3.5\%}{1 - 0.20} = \frac{3.5\%}{0.80} = 4.38\%\\).
### What is the TEY if a municipal bond yields 4.2% in a 25% tax bracket?
- [ ] 5.12%
- [x] 5.60%
- [x] 5.60%
- [ ] 5.70%
> **Explanation:** TEY = \\( \frac{4.2\%}{1 - 0.25} = \frac{4.2\%}{0.75} = 5.60\%\\).
### A bond offers a 5.5% tax-free yield. With a 30% tax rate, what is the taxable equivalent?
- [ ] 5.50%
- [ ] 6.50%
- [ ] 7.14%
- [x] 7.86%
> **Explanation:** TEY = \\( \frac{5.5\%}{1 - 0.30} = \frac{5.5\%}{0.70} = 7.86\%\\).
### Calculate the TEY for a 3% municipal bond if the tax rate is 40%.
- [ ] 5.00%
- [x] 5.00%
- [ ] 4.50%
- [ ] 4.00%
> **Explanation:** TEY = \\( \frac{3\%}{1 - 0.40} = \frac{3\%}{0.60} = 5.00\%\\).
### True or False: A higher marginal tax rate decreases the taxable equivalent yield of a municipal bond.
- [x] True
- [ ] False
> **Explanation:** As the marginal tax rate increases, the taxable equivalent yield becomes higher, meaning a tax-free bond offers more benefit compared to a taxable bond.
By mastering the calculations and theory behind taxable equivalent yield, you’re well-prepared for the exam and to offer informed advice on municipal bonds.