 Hello and welcome to the session in which we will discuss the taxability or lack of for interest on state and local Obligations which are called municipal bonds or simply put money bonds Simply put the interest from municipal bonds whether state or local is exempt exempt from taxation Now we need to understand why that's the first thing we need to understand. Why is that interest exempt? That's one thing too, is we need to understand how to perform the computation. So in other words, if I have to compare a Municipal bond or a state bond versus a corporate bond Which one will I choose? They might have different interest rate. Well, it all depends on my Tax bracket it all depends on my marginal tax rate And this is what we'll try to compute show you how to evaluate Whether an investment is better if you put your money in a municipal bond versus a corporate bond now I can see this topic to be tested much more in the future on the CPA exam The reason is simple The rule is this the rule is simple because all what we need to know is interest on municipal bond is tax exempt That's easy as long as you see the word municipality as long as you see the word State in that bond. Well, it's not included in taxable the trick The challenge is if you are giving the the opportunity to evaluate an investment in a municipal bond versus a Corporate bond and this is what we will do in terms of computation. Let's go ahead and get started before we proceed any further I have a public announcement about my company farhat lectures.com Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of Lectures multiple choice questions through false questions as well as exercises. Go ahead start your free trial today So let's start by discussing the why why is municipal bond a tax exempt? It's a form of subsidy indirect subsidy from the federal government Why because? Municipalities and government and state government are in competition with corporation So when you go to borrow money you have private corporation. You have municipalities you have state government and The municipalities and the state government are not as competitive as corporations So what the government says to make them competitive because the federal government don't want to keep financing state and local government What they told the investors is if you lend money to state government and municipalities No taxes on your interest. So it's an intent incentive for you to do what? To lend your money to state and municipal government because you don't have to pay taxes It serves two purpose one at lower the borrowing costs for the state and local corporate and local government The local government and the state government don't have to pay high rate as high as corporations also This policy benefits specifically high income taxpayers and we're gonna see why later on when we do when we perform Computation the higher your tax rate The higher is your after-tax yield So the higher is your tax rate the more you are going to keep in terms of Investing in a municipal bond. Why because you're earning money and let's assume you earned $100 and Another individual earned $100. We have individual a individual B This individual their tax rate is 30% this individual their tax rate is 10% Individual a because their tax rate is 30% they save $30 Taxpayer B because they they earn $10. They earn $100 They save $10 in taxes. So the higher your tax rate the higher is your saving Also municipal bond. We're gonna see later municipal bond interest is considered For social security benefit and inclusion So when you're computing whether you have to pay taxes on social security or not You have to include your municipal interest. So it helps you with saving taxes But if you are receiving money from social security, that's gonna be included in your income Why am I saying this? I'm saying this because what you want to do if you are receiving social security You don't want to pay taxes. Well, you'd say I would invest this in municipal bond Well, if it is in municipal bond The income is considered to determine whether your social security is that taxable or not. So for social security Tax purposes, they consider your municipal bond as interest in the computation whether you qualify to pay taxes or not Let's take a look at an example to see the benefit of municipal bond Let's assume you are offered a 12% corporate bond and a mini bond of them of 9% Well, everything else is equal No one will buy no one will buy the municipal bond of 9% Everyone's gonna buy the corporate bond assuming the risk is the same the corporate bond of 12% now also talking about risk We could always assume we could always fairly assume that government borrowing government bond has a lower risk Then private corporation, but for the sake of illustration, we're not gonna go into risk We're just gonna look at the numbers. So everything else is equal Everyone is going to buy the corporate bond because the corporate bond is paying 12% Then the municipality or the state government cannot raise money But remember the state or municipal bond would say look we're paying you 9% But whatever you earn on that money, it's all yours. You don't have to pay any federal taxes on it Now if you invest in the corporate bond and you earn interest you still have to pay taxes Now, how would you determine whether whether you invest in the mini bond or the corporate bond? So one way to do it is this way you will take the difference between the corporate and the mini bond Which is the difference between 12% and 9% is 3% and you will divide this by 12% you will get to 25% What is this 25% what does that determine? Here's what here's what you would say if if the buyer tax bracket is less Then the implicit tax rate of 25% So if your tax rate is less than 25% you are better off buying the Corporate bond because it's gonna earn more. We're gonna see how in a moment if the buyer tax rate is greater than the implicit rate of 25% you will buy the mini bond So who would buy the mini bond anyone with a tax rate of more than 25% they are better off buying the mini bond and Earning and earning 9% why is that? Because after you pay your taxes You're gonna keep more money with the municipal bond Okay. Well, let's see. Let's assume and a NB let's assume individual a invested a thousand dollar keep it simple a thousand dollar in the municipal bond so one thousand dollar times 9% this individual will earn $90 and will keep the whole $90 individual be Invested a thousand dollar they earned a 12% $120 now this individual as I mentioned I just chose Chose 20, you know, I already computed the implicit break-even which is 25% Then if that's assumed the individual is indeed in the tax rate of 25 and in the tax in the tax bracket of 25% if they Earned $120 now they're gonna keep only 75% out of it. So if we take 120 Keeping 0.75 because you have to pay you have to pay 25% in taxes Notice you keep you are keeping 90 put $90. Why because this This $120 you had to pay 25% another way if you take 120.25 you have to pay $30 in taxes after you pay the $30 in taxes you're left with $90. It's the same thing So that's why if your tax rate is above As above 25% you are better off going with The municipal bond because let's assume your tax rate make it 30% just for the sake of illustration So we kind of put this I want to make sure you understand this if your tax rate is 30% now we're dealing with a tax rate of 30% for individual a they don't care whether it's 20 50 30 They're always gonna earn $9 because they don't pay any taxes for individual be they're gonna earn 1000 times 12% is 120 now. They're only going to keep a point seven because they have to pay 30% 0.7 they are left with $84 Notice because they went with the corporate bond and their tax rate is more the tax rate were assuming 30% They are not well off and you can do the example assuming their tax rate is 20% Then they are better off with the corporate bond. So there's a break even point Okay, because we're going to take the corporate bond times one minus the tax rate to come up with the equivalent rate So the corporate bond is 12% times Whoops one minus 12% times one minus the tax rate Summon 25% will give us an equivalent rate of 9% just to kind of Confirm it confirm the computation. Let me show you the computation in a different way Let's assume a taxpayer and the 35% tax profit 35% tax bracket would only need A tax exempt bond with 3.9% to achieve the same after tax income as a taxable bond as 6% Simply put if you're in the 35 tax 35% tax bracket 35% tax bracket If someone offer you a mini bond 3.9 And a corporate bond of 6% basically they're equal to each other Okay, again, let's show you the computation You will take 0.39 you can take 0.39 another way to do it divided by one minus the tax rate And it's going to give you 6% This means that a taxpayer can earn a lower yield on a tax exempt bond And still maintain their desired income because if they paid if they earn the 6% On the corporate bond 6% and there's in the 35% tax bracket It means they're only going to keep from the 6% 0.65 because they have to pay 35% So if you take 6% times 0.65 they are left with 3.9% You want to be comfortable computing the After tax yield the after tax rate for municipal bond because this is what you're going to be asked on the exam Now you could also be asked simple question A list of interests and one or two of them is a municipal bond and they're gonna ask you to compute What's included in taxable income? Well, the municipal bonds are not included. That's easy Straightforward you need to know the rules But you might have to do this computation Computing the after tax return, which is very important. I showed it to you in different ways Make sure you understand it make sure you understand that it's it depends you have to do the computation But if you know how to perform this computation, you know For example for this example If the if your tax rate above 25% go with the mini bond if your tax rate below 25% go with the corporate bond You could do the same thing with You know using different interests and do the computation What should you do now go to far hat lectures to look at additional lectures mcq's Exercises resources that's going to help you understand this concept better Whether you are a cpa exam candidate enrolled agent or an accounting students understanding how after tax yield On municipal bond work is important. Good luck study hard and stay safe