Question

2. Ms. Drake is deciding between investing $50,000 in two different municipal bonds, both of which have the same risk. The first option is state of Colorado bonds paying interest of 3.35%. The second option is state of Texas bonds paying interest of 3.50%. All income from either bond investment is nontaxable at the federal level. Because Ms. Drake is a resident of Colorado, any income from the Colorado bond is nontaxable at the state level as well. However, any income from the Texas bond would be taxable in Colorado at Ms. Drake's state tax rate of 4.63%. Additionally, any state income taxes paid to Colorado on the Texas bond income would be deductible on Ms. Drake's federal tax return, benefiting her at her federal tax rate of 35%. Considering all of the above facts, which bond investment offers Ms. Drake the greater post-tax return - and by how much? Support your answer with clearly labeled calculations.

Below is how far I have gotten:

Benefit of federal tax rate: ?

Answer 1

Colorado Bond:

Interest Income = $50,000 * 3.35% = $1,675

Tax Rate for Income from Colorado Bond = 0%

Therefore, Post-tax return = $1,675

Texas Bond:

Interest Income = $50,000 * 3.50% = $1,750

Tax Rate for Income from Texas bond = 4.63%

Therefore, total income = $1,750 - (1,750 * 4.63%) = $1,669

As you can see, if Ms. Drake resident of Colorado invest in Colorado bonds, her income is higher as compared to her income from texas bonds.

Benefits of federal tax rate:

If an individual invests in a bond of their home state, there is rarely state tax charged. However, if they buy the bonds of another state, their home state may charge a tax on the bond.

Note: Interest earned from municipal bonds are usually tax-exempt, however, the investors should keep in mind the tax rates charged by federal and state in case he/she earns profit from selling the bond.