Please note the information below is intended to provide generalized information that is appropriate in certain situations.  It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.  The contents of the information provided below should not be acted upon without specific professional guidance.  Please call us if you have any questions.

Higher tax rates may have you thinking about allocating a portion of your investments to tax-exempts. After all, interest earned on tax-exempt investments not only escapes ordinary income tax rates that can be as high as 39.6%, but also the 3.8% Net Investment Tax (NIIT).

Of course there are lots of things to consider when making an investment, but when comparing taxable investments to tax-exempt investments one important factor is the after-tax return of the investment. Depending on your tax bracket and state tax consequences, the difference on the return between taxable and tax-exempt investments can be significant.

Municipal bonds usually carry a lower stated interest rate than taxable bonds of similar quality and safety. However, much of the appeal of investing in municipal bonds is that, depending on your tax rate, their after-tax yield can exceed the after-tax yield from a bond that pays a higher rate of taxable interest.

Warning: While interest on tax-exempt bonds is not subject to federal income tax, gains and losses on the sale of a tax-exempt bond are recognized. Thus, the tax effect of disposing of a tax-exempt bond prior to maturity should be considered. Controlling the timing of such gains or losses is easier when bonds are individually held versus through a mutual fund. Investors in tax-exempt bond mutual funds recognize gains passing through from the fund or, in some cases, when they dispose of their shares in the mutual fund.

A fairly straightforward formula can be applied to come up with comparative yields if you know your tax bracket. Here’s how it works:

Say you are in the 43.4% federal income tax bracket, so an additional dollar of taxable income would cost you 43.4 cents in additional tax. You have learned of an investment opportunity that offers a 3% tax-exempt yield. You want to know how this compares with your taxable investment opportunities.

1.   Subtract your tax bracket from 1. This equals 0.566 (1 – 0.434).

2.   Divide the tax-exempt yield (3%) by the figure arrived at above (.566).

The result is 5.3%. This means that you would need to earn 5.3% on your taxable investment to equal the 3% you would earn on the tax-exempt one.

If you know the taxable yield, but seek a comparable tax-free yield, the computation is even easier. Simply subtract your tax bracket rate from 100% and multiply the taxable yield by this result. That is, if you are in the 43.4% bracket, you will keep 56.6% (100% – 43.4%) of your income. Thus, a taxable 4% yield translates into an after-tax yield of 2.26% (4% × 0.566).

Note that the above computations only take the federal income tax into consideration. If your income is subject to state or local taxation that the tax-exempt income avoids as well, you would have to use your total effective tax rate in your calculations to arrive at a more precise result. Be careful in coming up with your effective state income tax rate. Remember that your state income tax is deductible for federal tax purposes. Thus, for a taxpayer in the 43.4% federal bracket, a 6% state income tax is effectively only 3.40% (6% × 0.566) because each dollar taxed by the state saves 43.4 cents in federal taxes.

There may be other adjustments to make as well, so if you seek greater precision or need any other assistance, give me a call.