After-Tax Basis Definition

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After-Tax Basis Definition

What Is an After-Tax Basis?

To determine whether bond has a greater yield, an after-tax basis is used to compare the net after-tax returns on taxable versus tax-exempt bonds.

Key Takeaways

  • After-tax bases compare the net after-tax returns on taxable and tax-exempt bonds to see which yields more.
  • The after-tax basis calculation enables investors to make educated choices in order to optimize the return on their portfolio.
  • Because investors must take on greater risk, most corporate bonds may have a higher yield than other tax-exempt bonds.

Understanding After-Tax Bases

Taxable bonds, such as corporate bonds, may provide greater yields than tax-free bonds, such as municipal bonds. Calculating the after-tax basis will enable an investor to make smarter decisions that will optimize the return on their portfolio.

Given the increased risk, most corporate bonds may provide a greater return than their tax-exempt counterparts. While an investor may be ready to accept the additional risk, they will want to guarantee that the after-tax basis is larger than that of a similar municipal bond. To appropriately evaluate the return on investment (ROI) of the two products, the amount of tax on the corporate bond earnings stream must first be calculated. Earnings are subtracted from taxes to determine the actual yield. Only then may an investor compare the returns of a taxable bond with a tax-exempt bond.

Calculating how much a bondholder will pay in tax may need the advice of a financial or tax specialist, depending on the conditions of the bond’s redemption. An after-tax basis comparison might be difficult to calculate. This problem stems from the various approaches used to calculate corporate bond taxes. In general terms:

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  • All corporate bonds will be taxed on their interest profits, both at the state and federal levels.
  • If the redemption occurs before the maturity date, the proceeds may be liable to capital gains tax.
  • Some bonds do not pay interest on coupons and are only redeemable at maturity for their face value. Investors buy no-coupon bonds at a discount, and the difference between the purchase price and the redemption value at maturity is taxable.

Considerations Besides After-Tax Bases

When you calculate the after-tax yield on a corporate bond, you may compare it to the return on a tax-exempt bond. That comparison, however, does not account for all of the variables that influence whether a taxable or tax-exempt bond is a superior investment.

Many investors, for example, choose municipal bonds because they have an exceptionally low default risk, making them a much safer investment instrument. Corporate bonds, on the other hand, may carry a larger risk. Some may provide very high rates, but that greater yield is almost certainly correlated with a larger risk.

Credit rating organizations, such as Moody’s, may tell prospective investors about a company’s creditworthiness and what an investor might anticipate. Some corporate bonds are also callable, which means that the issuing corporation may redeem the obligations before they mature. Investors get a set amount dependent on when the bonds are called, but must then reinvest these proceeds in the open market. Frequently, they will not be able to get the same returns as the initial investment.

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