After-Tax Yield

Well, we'll presume you know what standard yield is. If not, then the dark answer is just a click away.

Okay, so you have a stock trading for 20 bucks a share; it pays a quarter a share 4 times a year, or a dollar a year in dividends. Its dividend yield is 1 over 20, or 5 percent. But you the investor pay tax on that buck a share of sweet hot dividend love.

If you’re a 35% bracketed taxpayer...that is, you pay 35% tax on the last dollar of income...then you keep only 65 cents on each dollar of dividend income you receive. And yes, we note that there is both federal and state and sometimes other taxes that go in here, like the Obamacare flavors, or county taxes...but in total, if you pay 35% tax on that buck, then your real after-tax yield is a lot less than the 5% the company distributes to you.

You calculate your after-tax yield by replacing that "gross" dividend of a buck with the 65 cents of dividend you keep after tax in the numerator…and then 20 bucks you paid for that share of GentlyUsedPacemakers.com stays in the denominator.

It looks like this:

65 cents divided by 20 bucks, which is 3.25%. That 3.25 percent is your after-tax yield. 

So that’s as it applies to stocks. What about as it applies to bonds? And in a way, this calculation matters a lot more, because there is an entire industry in muni bonds, which pay lower total rates of interest, but which are generally insulated from paying taxes. So in a way, muni bonds compete against fully taxable corporate bonds for your bond-investing dollar.

Tax rates for qualified dividends from equity investments are usually meaningfully lower than ordinary income rates…so let’s look at the individual paying 35% marginal tax on long-term gains.

They are likely paying something close to 50% tax on ordinary income. So we have a tale of two bonds: Foam Depot Corporation, whose bonds pay 7% interest...and “We’re In the Muni” City Muni bonds, which pay 4%. The two bonds are of identical credit risk. If you’re Joe Hardworker, high taxpayer, and supporter of government pork, then which of these two bonds gives you better after-tax yield?

Well, if you pay 50% ordinary income tax, then your 7% is half, or 3.5% after tax. And your muni bond carries no tax liability to you, so the 4% gross is the 4% net as well.

Answer? Go with the muni bond, and you, too, will be, uh…in the muni.