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 Dividend Yield?4 Views
finance a la shmoop what is dividend yield? ah dividends the sign of the truly
well-to-do company well when a company has nothing better to do with its cash
and it has bought all of the corporate jets it wanted put in fountains in the [Fountain of water appears]
executive suite bathrooms and offered massage and dog therapy to all of its
employees it can then at its own discretion pay a dividend to its common
shareholders of record common shareholders yep that's who gets
dividends if you're an employee at a company and got say a bunch of stock [Employee stood beside company]
options when the company signed you you don't get dividends unless you buy out
your stock options and turn them into actual shares or common stock yeah well
dividends get paid quarterly in almost all companies in the US and companies
typically "declare" what their dividend will be a year or two or
three in advance if they can Wall Street does not like surprises so Daddy [Wall Street appears]
Warbucks rifles has made Bank in this neo zombie apocalypse and after buying
all of the anti zombie spray it ever wanted along with the jets and fountain
and doggy meditation classes well the company has extra cash it plans to [Dividends by a company building]
dividend out that cash on a regular basis and just like most companies
it has forecasted earnings three or four years or more into the future and this
dividend payout will be some relatively modest percentage of earnings like if
earnings will be something like 50 million then 70 million then 90 million
x3 years while the dividend might be declared as 25 million dollars a year [Dividend payments appear]
while doing the math here that'd be a 50% of earnings payout ratio in year one
but if they keep the dividend flat and don't raise it well it would just be
then twenty five over seventy or thirty six percent payout in year two and if
they still keep it flat in your three well it would just be a 25 over 90 there
that's a 28 percent payout and in real life odds are good they'd raised their
dividend if their earnings performance was you know this good [Thumbs up appears]
good performance right so what then is the dividend yield here to investors who
own a share of common stock well if the stock was trading for 40 bucks a share
and the dividend was 60 cents than the dividend yield would be 60 over 4000 or
0.6 60 cents there over the 40 bucks or 1.5 percent if the stock ran up to 60
bucks a share and the yield remained 60 cents well than the yield would be one
percent right 60 over 6,000 there yeah and if the stock tanked to be just 10 [Stock plot line crashes]
bucks a share and the dividend was still 60 cents a share the yielded be 6
percent so you can imagine how high dividend yields kind of cushion the
downside of stock like getting 6% it's pretty safe you know people are gonna be
happy to just collect your divvy right all right well that's yield a la
dividend and what should you do with the few bucks you'll make each month from [Man discussing dividends]
your dividends well you might want to stock up on that zombie spray in case
that things go awry [Person spraying zombie with anti zombie spray]
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