Taxes Exam Review Part 2

ID: A

Taxes Exam Review (Part 2) True/False Indicate whether the statement is true or false. 1. BOND INTEREST TAXES 2. Corporate bond interest (for individuals) is taxed as income. 3. Bond interest is taxed as ordinary income. 4. MUNI BONDS 5. Muni bonds are bonds that are issued by state and local governments and may also be issued by utility companies or non-profit organizations. 6. Muni bond yields are usually lower than taxable yields. 7. Interest from muni bonds are exempt from federal income taxes. 8. Key Formulas • After-Tax Yield =Taxable Yield × (1 − Tax Rate) Tax Free Yield • Taxable Equivalent Yield = (1 - Tax Rate) 9. Interest from muni bonds are always exempt from state income taxes. 10. Suppose an investor has a combined state and federal income tax rate of 35%, then a muni-bond with a tax-free yield of 5.00% would be equivalent to a taxable bond with a 7.45% yield. 11. Suppose an investor has a combined state and federal income tax rate of 35%, then a taxable bond with a 6.5% yield has an after-tax yield of 4.225%. 12. It is possible to have $1,000,000 or more in interest income, not pay any federal income taxes on the interest, and not be breaking the law for failure to pay income taxes. 13. For an investor in a combined 35% federal and state tax bracket, a 4% muni-bond yield is equivalent to 5.5% taxable yield. 14. An investor with a corporate bond that pays 6% and a combined tax bracket of 30% has an after-tax yield of 5.2%. 15. The higher the tax bracket for an investor, the more appealing muni-bonds become. 16. CHARITABLE CONTRIBUTIONS

1

Taxes Part 1

ID: A

17. If you are in a combined tax bracket of 40%, then a $1,000 donation to a charity will reduce your tax liability by $400. 18. MORTGAGE INTEREST 19. Because mortgage interest is deductible, the interest cost is reduced. 20. If you have a mortgage with a 6% interest rate and a 30% combined bracket, then your taxable equivalent interest rate is 6% × (1 − 0.30) = 4.2% 21. HEALTH INSURANCE FROM EMPLOYER 22. If your employer pays $6,000 in health insurance premiums on your behalf and you are in a combined tax bracket of 25%, then you avoid paying income taxes on that $6,000 in compensation. 23. RETIREMENT CONTRIBUTIONS 24. If you are in a combined tax bracket of 40%, then a $1,000 pre-tax conribution to a retirement account will reduce your tax liability by $400. Problems 25. Complete the following table Muni Bond Yield

Tax Bracket

3% 4% 5% 6% 7%

40% 40% 40% 40% 40%

Taxable Equivalent Yield

Muni Bond Yield

Tax Bracket

3% 4% 5% 6% 7%

25% 25% 25% 25% 25%

Taxable Equivalent Yield

26. Complete the following table Taxable Bond Yield 3% 4% 5% 6% 7%

Tax Bracket 40% 40% 40% 40% 40%

After Tax Yield

Taxable Bond Yield 3% 4% 5% 6% 7%

2

Tax Bracket 25% 25% 25% 25% 25%

After Tax Yield

ID: A

Taxes Exam Review (Part 2) Answer Section TRUE/FALSE 1. ANS: T 2. ANS: T 3. ANS: T Unless it is muni-bond interest, it is taxed as ordinary income. (Muni-bond interest is tax free.) This means that interest is subject to federal and state income taxes. But bond interest isn’t subject to social security or medicare taxes. 4. ANS: T 5. ANS: T 6. ANS: T For similar bonds (in terms of quality and maturity), muni yields are usually lower than taxable yields. 7. ANS: T 8. ANS: T 9. ANS: F Most states make their own muni bonds tax free, but not all do. Also, most states will tax muni bonds that are used in another state. 10. ANS: F It would be equivalent to a yield 7.69%. 11. ANS: T 12. ANS: T You could have invested in muni bonds that are exempt from state and federal income taxes. 13. ANS: F 4% 4% = = 6.154% . The taxable equivalent yield for the muni-bond is 1 − 0.35 0.65 14. ANS: F The after tax yield is 70% of 6% or 4.2%. 15. ANS: T 16. ANS: T 17. ANS: T 18. ANS: T 19. ANS: T The mortgage interest deduction reduces a taxpayer’s liability. (Assuming that the tax payer itemizes and does not take the standard deduction.) 20. ANS: T 21. ANS: T 22. ANS: T 23. ANS: T 24. ANS: T

1

ID: A PROBLEM 25. ANS: Use the taxable equivalent yield formula. 26. ANS: Use the after-tax yield formula.

2