Which investment would provide the best after-tax return in the same bracket scenario if options include a 6.5% U.S. government bond?

Which investment would provide the best after-tax return in the same bracket scenario if options include a 6.5% U.S. government bond?

• A. 7% AAA corporate bond
• B. 6.5% U.S. government bond
• C. 4% in-state municipal bond
• D. 4.5% out-of-state municipal bond

Answer: (B)

This question tests how taxes affect the actual return you receive. After‑tax yield is what matters, and different income sources are taxed differently. A government bond (Treasury) pays interest that is subject to federal tax but not state or local taxes. Municipal bonds pay interest that is generally exempt from federal tax; in-state municipal bonds are also exempt from state taxes, while out-of-state munis are taxed by your state. Corporate bonds pay interest that is taxed at both federal and state levels (no tax exemption). Given those rules, the 6.5% government bond is attractive in the “same bracket” scenario because you reduce the impact of taxes by not paying state taxes on its interest. The in-state municipal option yields 4% that is tax-free at both federal and state levels, which is lower than the after-tax result of the government bond in most tax brackets. The out-of-state municipal option, while tax-exempt federally, loses some value to state taxes. The corporate bond, though higher in nominal yield, is reduced by both federal and state taxes. Putting these together, the after-tax return on the 6.5% government bond is typically higher than the others in this setup, making it the best choice.

This question tests how taxes affect the actual return you receive. After‑tax yield is what matters, and different income sources are taxed differently.

A government bond (Treasury) pays interest that is subject to federal tax but not state or local taxes. Municipal bonds pay interest that is generally exempt from federal tax; in-state municipal bonds are also exempt from state taxes, while out-of-state munis are taxed by your state. Corporate bonds pay interest that is taxed at both federal and state levels (no tax exemption).

Given those rules, the 6.5% government bond is attractive in the “same bracket” scenario because you reduce the impact of taxes by not paying state taxes on its interest. The in-state municipal option yields 4% that is tax-free at both federal and state levels, which is lower than the after-tax result of the government bond in most tax brackets. The out-of-state municipal option, while tax-exempt federally, loses some value to state taxes. The corporate bond, though higher in nominal yield, is reduced by both federal and state taxes. Putting these together, the after-tax return on the 6.5% government bond is typically higher than the others in this setup, making it the best choice.