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Suppose that you are a saver with a choice of three financial assets that are identical in every way except their nominal interest rate and taxability. Calculate the after tax real yield for each of the following three assets and choose which of the three assets is the best option if inflation is expected to be 1.75% annually with a federal income tax rate of 26%. (There is no price of assets given)?
Asset 1: A corporate bond with an interest rate 7.5% in a state with an income tax rate of 4.5%.
Asset 2: A Treasury bond with an interest rate 6.25% in a state income tax rate of 0%.
Asset 3: A municipal bond with an interest rate 5.0% in a state with an income tax rate of 5.5%.

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Answer:

The best asset is the number 1.

Explanation:

Asset 1

Total tax=26+4.75=30.75% and rate of return is 6.5% so net rate of returm after tax=(0.6925)(6.5%)=4.501

Asset 2

Total tax=26% and rate of return is 5% so net return after tax=(0.74)(5%)=3.7%

Asset 3

Interest rate is 4% with no tax. So net interest rate tax=4%

So Asset 1 is the best option where net return after inflation will be 4.50-2.15=2.35%