Comparing Taxable vs. Tax-Exempt Investment Yields

With rising tax rates, some taxpayers are considering allocating at least a portion of their investments to tax-exempt investments. 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 income tax (NIIT).

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. A fairly straightforward formula can be used to compare yields for taxable vs. tax-exempt investments if you know your income tax bracket.

Say you are in the 43.4% federal income tax bracket (including NIIT), 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 effectively 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 (0.566).

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 from 1 and multiply the result by the taxable yield. That is, if you are in the 43.4% bracket, you will keep 56.6% of your income. Thus, a taxable 4% yield translates into an after-tax yield of 2.26% (4% × 0.566).

Of course, these 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. There may be other adjustments to make as well, so if you seek greater precision, give us a call and we will run some more exact numbers for you.

Please contact Martini, Iosue & Akpovi by phone at (818) 789-1179 if you have any questions or would like more information.


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