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 the Difference Between ...132 Views
Finance, a la Shmoop. [title page]
What's the difference between normal, inverted, and flat yield curves, and what to they tell
us?
All right, well let's start with the basics.
Yield curve... ooh, sexy term. [guy talks about yield curves]
Say it a lot and people will think you know a lot about finance.... or that you're really [people are pretty impressed]
into slowing down while making gradual left turns. [pig thanks slow driver]
But in finance, a yield curve is just a graphic representation of bond yields, from "maturing [yield curves defined]
soon" to "not maturing for a really long time."
So here's a yield curve. [yield curve illustrated]
Note that the ticks on the bottom are time and, on the left--the vertical y-axis there--it's
percentage, or yield.
Well, this particular curve slopes oh-so-gently upward. [upward slope demonstrated]
You can see that bonds maturing in three months yield 2% and bonds maturing in 30 years yield
4.5%.
What does this say?
Well, it says that the debt markets believe that interest rates will be meaningfully higher [diagram explained]
in the future--like, more than double--and that, to some extent, there's risk in getting
those bonds paid off.
That is, money tangibly ready to be paid off in the next two months carries a lot less
investment risk than bonds three decades away. [roaches discuss bills]
Yeah, you never know, we could have this... [roaches watch nuclear destruction of world]
So this is a normal curve: Money near term yields less than money due far away.
Well, most of the time, this is how yield curves look.
But think about an era where the government is desperately fighting inflation and it raises [government fights inflation]
short-term borrowing rates massively. [rates increase]
Well this, in fact, happened in the 1970s when Vietnam's war economy, coupled with a [Vietnam War footage]
bunch of other elements, produced roaring inflation in the U.S.
So the Fed then raised short-term rates into the double digit zone, but most investors [rates increase]
believed that these very expensive short-term interest rates would stop people from borrowing
and buying stuff.
Think about your credit card charging you 25% a year in interest. [big credit card bill]
Ugh, that's a lot.
It'll make you think twice about putting that belly button ring set you saw at the mall
on your AmEx. [person doesn't buy belly button ring]
So when people stopped buying things on credit, well, they bought a lot less and the economy [tumbleweed in mall]
cooled, and then the Fed went ahead and lowered rates and the yield curve went back to normal. [rates decrease]
But for a while, the curve was inverted. [inverted curve demonstrated]
That is, is started with short-term rates very high, and then long-term rates were cheaper.
And as you might be able to guess, somewhere in the middle there, as the curves crossed
over, there was a short period where the yield curve was pretty flat. [flat yield curve demonstrated]
That is, the price of renting money is the same whether you're borrowing it for three
months or 30 years.
You know, that same 3.5% kind of rent.
Got it?
So now you've got curves, and you know how to use 'em. [pig admires curves]
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