After-Tax Real Interest Rate

  

Categories: Econ, Metrics, Regulations, Bonds

So you own a bond. It pays 5 percent interest and you pay 40 percent marginal tax rate. After tax, you're making 3 whopping percent. But we have inflation of 2 percent a year...which eats into the real, net returns on that bond. So if the cash paid by that bond is worth 98 percent of what is was, on a real, interest-reflected rate, then that net 3 percent is worth .98 times 3 percent...or 2.9 percent. That's the After-Tax Real Interest Rate. 

Related or Semi-related Video

Finance: What is Aftertax Yield?8 Views

00:00

Finance a la shmoop... what is after-tax yield, well we'll presume you [Yield definition on 100 dollar bill]

00:08

know what standard yield is yeah okay so you have a stock trading for a

00:12

convenient exactly 20 bucks a share it pays a quarter a share four times a year

00:17

is a dividend or a dollar a year total in dividends its dividend yield is one

00:23

over twenty or five percent right you buy share for 20 bucks you get a dollar a

00:28

year back but you the investor pay tax on that buck a share of sweet hot

00:33

dividend love if you're a 35 percent bracketed taxpayer that is you pay 35 [35% taypay circled]

00:38

percent tax on the last dollar of your income well then you only keep 65 cents

00:43

on each dollar of dividend income that you receive and yes we note that there

00:47

is both federal and state and you know sometimes other taxes that go in here [List of taxes on sticky note]

00:52

like the Obamacare flavors or other county taxes but in total we're just

00:57

saying let's make up a story here that if you pay 35 percent tax on that buck

01:01

then your real after-tax yield is a lot less than the 5 percent the company

01:06

distributes to you, you calculate your after-tax yield by replacing that

01:11

"gross" dividend of a buck with a 65 cents of dividend that you keep [After-tax yield calculation]

01:16

after-tax in the numerator like that and then that 20 bucks you paid per share of

01:21

gently-used pacemakers dot-com stays in the denominator down there it looks like

01:26

this 65 cents divided by 20 bucks and that's 3.25 percent that

01:31

is 3.25 percent is your after-tax yield so that's as it applies [Man discussing after-tax yield to stock]

01:36

to stocks what about as it applies to bonds well in a way this calculation

01:41

matters a lot more because there's an entire industry in muni-bonds which pay

01:45

lower total rates of interest but which are generally insulated from paying [Person holding a muni-bond]

01:49

taxes so in a way muni bonds compete against fully taxable corporate bonds

01:54

for your bond investing dollar well tax rates for qualified dividends

01:58

meaning they're qualified for the various deductions from equity

02:01

investments are usually meaningfully lower than ordinary income rates so

02:06

let's look at the individual paying 35 percent marginal tax on long [Magnifying glass focuses on womans face]

02:10

term investment gains well they're likely paying something close to 50% tax

02:14

on ordinary income so we have a tale of two bonds foam depot corporation whose

02:19

bonds pay 7% and we're in the muni-city muni bonds which pay 4% which is better

02:25

the two bonds are of identical credit risk and if you're Joe hard-worker high [Hoe hammering a roof]

02:30

tax payer and supporter of government pork then which of these two bonds gives

02:34

you a better after-tax yield well if you pay 50 percent ordinary income tax then

02:40

you're 7% on that corporate is half or 3.5% after-tax that's the after-tax

02:46

yield got it and your muni bond carries no tax liability to you so the 4%

02:51

gross is the four percent net as well answer well go with the muni bond

02:56

and you two will be you know in the muni [Man discussing muni-bond after-tax yield and hat lands on his head]

Up Next

Finance: What is a Tax Deduction?
102 Views

What is a tax deduction? Tax deductions decrease the amount of taxable income reported so that less tax is owed. For everyday civilians, these dedu...

Find other enlightening terms in Shmoop Finance Genius Bar(f)