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.
Related or Semi-related Video
Finance: What is Aftertax Yield?8 Views
Finance a la shmoop... what is after-tax yield, well we'll presume you [Yield definition on 100 dollar bill]
know what standard yield is yeah okay so you have a stock trading for a
convenient exactly 20 bucks a share it pays a quarter a share four times a year
is a dividend or a dollar a year total in dividends its dividend yield is one
over twenty or five percent right you buy share for 20 bucks you get a dollar a
year back but you the investor pay tax on that buck a share of sweet hot
dividend love if you're a 35 percent bracketed taxpayer that is you pay 35 [35% taypay circled]
percent tax on the last dollar of your income well then you only keep 65 cents
on each dollar of dividend income that you receive and yes we note that there
is both federal and state and you know sometimes other taxes that go in here [List of taxes on sticky note]
like the Obamacare flavors or other county taxes but in total we're just
saying let's make up a story here that if you pay 35 percent tax on that buck
then your real after-tax yield is a lot less than the 5 percent the company
distributes to you, you calculate your after-tax yield by replacing that
"gross" dividend of a buck with a 65 cents of dividend that you keep [After-tax yield calculation]
after-tax in the numerator like that and then that 20 bucks you paid per share of
gently-used pacemakers dot-com stays in the denominator down there it looks like
this 65 cents divided by 20 bucks and that's 3.25 percent that
is 3.25 percent is your after-tax yield so that's as it applies [Man discussing after-tax yield to stock]
to stocks what about as it applies to bonds well in a way this calculation
matters a lot more because there's an entire industry in muni-bonds which pay
lower total rates of interest but which are generally insulated from paying [Person holding a muni-bond]
taxes so in a way muni bonds compete against fully taxable corporate bonds
for your bond investing dollar well tax rates for qualified dividends
meaning they're qualified for the various deductions from equity
investments are usually meaningfully lower than ordinary income rates so
let's look at the individual paying 35 percent marginal tax on long [Magnifying glass focuses on womans face]
term investment gains well they're 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% and we're in the muni-city muni bonds which pay 4% which is better
the two bonds are of identical credit risk and if you're Joe hard-worker high [Hoe hammering a roof]
tax payer and supporter of government pork then which of these two bonds gives
you a better after-tax yield well if you pay 50 percent ordinary income tax then
you're 7% on that corporate is half or 3.5% after-tax that's the after-tax
yield got it and your muni bond carries no tax liability to you so the 4%
gross is the four percent net as well answer well go with the muni bond
and you two will be you know in the muni [Man discussing muni-bond after-tax yield and hat lands on his head]
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