Not all types of income are taxed at the same rate; income from certain investments is taxed at a preferential rate. Thus, when comparing investments, it's important to consider the aftertax return of the investment instead of simply looking at the beforetax return.

The aftertax return is calculated as follows:

aftertax return = beforetax return x (1 marginal tax rate)

For example, let's consider a corporate bond that pays 6% interest and a taxexempt municipal bond that pays 4% interest. If the interest income from the corporate bond is taxed at a rate of 35%, then the aftertax return of the corporate bond is just 3.9%. Think about this way: if you invested $100 in the corporate bond you would receive $6 of interest annually, but that $6 of income would be taxed at a rate of 35%, resulting in taxes of $2.10 ($6 x 35%). Thus, you received $6 of interest but after paying taxes on that income you were left with just $3.90. The municipal bond, on the other hand, is taxexempt which means the tax rate on interest earned from the municipal bond is zero. Thus, if you invested $100 in the municipal bond you would receive just $4 of interest but you would get to keep the entire $4 (since the tax rate is 0%). Thus, the municipal bond would have a higher aftertax rate of return even though the corporate bond would have a higher beforetax rate of return.
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