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 Yield to Maturity?6 Views
finance a la shmoop what is yield to maturity yield it's the dough you get
back from your investment in a bond here's a thousand-dollar bond here's the [pigeons sitting on a line]
coupon of 7% so the yield is 7% while the bond lasts for 10 years and then
after paying you 70 bucks a year for a fat and happy decade of sitting on your
Duff collecting your interest you get your grand back and well that's it right [check changes hands]
um no well what happens if you bought that bond for nine hundred bucks or
twelve hundred bucks or some other random amount yeah way more complex well
there are two ways you make money from investing in a bond first there's the
interest as we just outlined 70 bucks a year the semi annual festival of dances [people dancing together]
when the interest payment is made right it's 35 bucks twice a year easy but then
there's the appreciation of the principle of the bond and yeah it could [flying crow starts inflating]
be depreciation of it - all right you bought a 6% yielding bond at a discount
to its thousand-dollar par value like say you paid 92 cents on the dollar nine
hundred twenty bucks for a thousand dollar par value bond well over ten
years you hold that bond until it matures it will appreciate in value I
call it - eight bucks a year and then it will pay to investors that thousand [check change hands]
dollar par value well yield to maturity which doesn't apply to shmoop writers
takes into account both sets of cash flows into your wallet the interest
yield plus the appreciation of the principle of the bond so in this case
the bond was paying interest of 60 bucks a year but then it also had appreciation
of eight bucks a year for a total of 6.8%
or 68 bucks a year in appreciation all right is this all there is to it you
just throw in a straight line number therefore the annual appreciation eight
bucks every year smoothly that's of the principle until it hits par and then
you're done no not at all life is never that simple all kinds of curveballs will
be thrown at you all over your head there and you think about you to [flying bird dodging balls]
maturity okay here's one for starters what about the time value of money
remember that thing ie the cash that you get twice a year in bond interest well
couldn't you reinvest that money elsewhere like it
moment the moment you collected 10 years earlier before bond matures and make
more money well sure you could and what about the application of straight-line
depreciation to the gain of 80 bucks over 10 years like why does the bond
depreciate exactly eight dollars a year in value instead of Raoh maybe less in
the early years and more in the later or or vice versa
yeah lots of curveballs and some of these are just accounting decisions or [businessman studying papers]
the way things are done and the way things are done in bond land is usually
driven largely by the way the IRS wants to tax you got it so that whole [Uncle Sam walking down the street]
straight-line depreciation thing and that's largely an IRS driver and here's
another some bonds are callable early so what if this bond was callable after
five years but at 102 or a $20.00 premium per bond or a thousand twenty
well then yeah the yield calculation is different and it's normally called out
as a quote yield to worst unquote or rather yield to the worst possible
outcome of the bond other than it going bankrupt or you know not paying on time [coins dropping]
in this case the yield to worst would be an appreciation from nine twenty two a
thousand twenty or a gain of a hundred bucks then over just five years so you'd
add twenty bucks a year to the dividends of sixty bucks a year and you'd get a
well at least a notional yield here then of eight percent right if the bonds were
in fact called at ten twenty thousand twenty bucks each got at eight percent
or does that yield to worst is that the worst you knuth know it's not the worst
at all the normal trajectory of this bond has it maturing in a decade and at
par not at a premium to par that ten twenty thing so it isn't bad to be a
yield to Wurster in this case it's just that if the bond is called early well [crow flying]
that would be the worst it would do other than like you know not pay off or
go bust and obviously this is all about appreciation when you buy it
depreciation you know works the same so just relist into this video in Reverse
and sometimes worst ain't so bad you [two birds on a line]
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