Comparing Taxable and Tax-Free Yields
Posted On March 12, 2017
Comparing Taxable and Tax-Free Yields
|$5,000 taxable bond paying 5% interest
|$5,000 municipal paying 3.5%
|Federal tax bracket
|Paid in taxes
Note:This hypothetical example is intended only as an illustration and does not reflect the return of any specific portfolio.
It’s important to consider a bond’s after-tax yield–the rate of return earned after taking into account taxes (if any) on income received from the bond. Some bonds–for example, municipal bonds (“munis”) and U.S. Treasury bonds–may be tax exempt at the federal and/or the state level. However, most bonds are taxable.
Consider what you keep
A tax-exempt bond often pays a lower interest rate than an equivalent taxable bond, but may actually have a higher yield once the impact of taxes has been factored in. Whether this is true in your case depends on your tax bracket. It also can be affected by whether you must pay not only federal but state and local taxes as well.
For example, let’s say you consider investing in either Bond A, a tax-exempt bond paying 4% interest, or Bond B, a taxable bond paying 6% interest. You want to find out whether Bond A or Bond B would be a better investment in terms of after-tax yield. For purposes of this illustration, let’s also say you are in the 35% federal tax bracket and do not have to pay state taxes.
You determine that Bond A’s after-tax yield is 4% (the same as its pretax yield, of course). However, Bond B’s yield is only 3.8% once taxes have been deducted.
You’d probably decide that tax-exempt Bond A would be better because of its higher after-tax yield.
The impact of being taxfree
In order to attract investors, taxable bonds typically pay a higher interest rate than tax-exempt bonds. Why? The associated tax exemption effectively increases the after-tax value of a tax-free bond’s yield. That tax advantage can mean a difference of several percentage points between a corporate bond’s coupon rate–the annual percentage rate it pays bondholders–and that of a muni with an identical maturity period.
Still, as the earlier example demonstrates, a tax-free bond could actually provide a better after-tax return. Generally, the higher your tax bracket, the higher the tax-equivalent yield of a muni bond will be for you.
Comparing apples to oranges
To make sure you’re not comparing apples to oranges, you can apply a simple formula that involves your federal marginal tax rate (the income tax rate you pay on the last dollar of your yearly income). The formula depends on whether you want to know the taxable equivalent of a tax-free bond, or the tax-free equivalent of a taxable bond. Calculating the taxable equivalent of a tax-free bond requires subtracting your marginal tax rate from 1, then dividing the tax-free bond’s annual yield by the result. To calculate the tax-free equivalent of a taxable bond, you subtract your tax rate from 1, then multiply it by the taxable bond’s yield.
If a taxable bond also is subject to state and local taxes and the tax-exempt isn’t, the tax-equivalent yield on the tax-free bond could be even lower and still come out ahead.
A financial professional can help you compare taxable and tax-free bonds, and evaluate how to maximize the benefits of both. However, there is no assurance that working with a financial professional will improve investment results.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax and legal professional based on his or her individual circumstances.
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|Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2017.