Question

Tonya, who lives in California, inherited a $100,000 State of California bond in 2018. Her marginal Federal tax rate is 35%, and her marginal state tax rate is 5%. The California bond pays 3.3% interest, which is not subject to California income tax. She can purchase a corporate bond of comparable risk that will yield 5.2% or a U.S. government bond that pays 4.6% interest. Hint: Don't forget to calculate any potential federal tax savings from a deduction from CA state taxes. What is the after-tax income form each bond?

Answer 1

Answer:

U. S. Government Bond:

Interest payment = 4.6%

Interest on U. S. Government Bond is taxable at Federal level only.

Hence after tax income from U. S. Government Bond = Interest rate * (1 - marginal Federal Tax) = 4.6% * (1 - 35%) = 2.99%

California Bond:

Interest payment = 3.3%

Interest is not subject to California Income tax.

Most California state bonds are exempt from both Federal and California State Income Tax. However, certain bonds do not meet all tax exempt rules; hence in some cases Federal Tax may be applicable.

In this case it is given that interest not subject to California Income tax.

Hence,

If Federal Tax is applicable, after-tax income = 3.3% * (1 - 35%) = 2.145%

If Federal Tax is not applicable, after-tax income = 3.3%

Corporate Bond:

Interest payment = 5.2%

Both California state tax and Federal Tax are applicable. However, tax payer can claim deduction of either state income tax or state sales tax in itemized deductions for Federal Tax purpose.

As such effective combined (State and Federal) Tax rate = Marginal State Tax rate + Marginal Federal tax rate * (1 - Marginal State Tax rate) = 5% + 35% * (1 - 5%) = 38.25%

Hence after tax income from corporate bond = 5.2% * (1 -38.25%) =3.211%