Juan was considering purchasing an interest in a tax-exempt bond fund for $100,000 when he discovered that the interest must be included on his state income tax return. The interest rate is 5%. His marginal Federal tax rate is 35%, and his marginal state income tax rate is 10%. Juan itemizes his deductions on his Federal income tax return. As an alternative, Juan can purchase a state bond (a double-exempt bond) yielding 4.9% interest that is exempt from both Federal and state income tax. Which investment would yield the greater after-tax return?

The double-exempt bond is the preferred investment because it has a higher after-tax return Tax benefit.

Explanation:

Calculatation of the after-tax return on both bonds

1) The double-exempt bond does not pay state or federal income taxes.

After-tax return =

Before-tax return = 4.9%

2) The tax-exempt bond is the state income taxes, but not federal in which the states can decide whether to tax their bonds or not.

Interest Income (100,000 * 5%) 5,000

Less: State taxes at 10% (5,000 * 10%) (500)

Tax benefit from deduction of state taxes on federal return (500 * 35%) 175

After-tax Income 4,675

After-tax return = 4,675/100,000 = 4.675%

Therefore the double-exempt bond is the preferred investment because it has a higher after-tax return Tax benefit.

Hence the state income tax will be deductible on Juan's federal tax return and Juan's federal taxable income will be lower or lesser by $500 which will produces tax savings at his federal marginal tax rate of $500 * 35% = $175.