By JLP | October 20, 2006
Let’s say you have the choice between two fixed-income options:
A 5.00% taxable yield or a 4.50% tax-free yield.
We’ll also assume that you are in the 28% tax bracket.
So, how do you know what option is best for you?
Well, there’s a really simple formula that you can use to calculate a tax-equivalent yield so that you can compare the yields on an equal basis. The formula is:
So, for this example, the formula would like this:
So, this tells us is that if you are in the 28% tax bracket, you need to find a fixed income investment that yields AT LEAST 6.25% BEFORE TAX in order to get the same after-tax yield of a 4.50% tax-free. In this case you would be much better purchasing the tax-free option. Make sense? If not, let’s look at it another way to test our math.
Again, we will assume that you are in the 28% tax bracket and you find an investment with a taxable yield of 6.25%. Since this yield is taxable, you won’t get to keep it all. So, you want to calculate how much of that yield is going to be left after taxes. So, you can perform the following calculation, which is an alteration of the formula used above:
See, it works!
We can also calculate what the after-tax yield is on the 5.00% yield:
Which would you rather have 4.50% tax-free or 3.60% tax-free? I think it is a pretty easy choice.
A couple of things to understand about tax-free yields:
1. The higher your tax bracket, the more advantageous a tax-free yield becomes. Take a look at the graphic I put together:
So, what may be good for a high-income doctor may not necessarily be good for you. Also, what the heck are you doing getting investment advice from a doctor?
2. Just because a bond is tax-free DOES NOT mean you will never owe taxes on it. Say what? Capital gains from bonds (even tax-free bonds) are taxable. So, if you purchase a bond and then interest rates fall, the value of your bond will go up. If you SELL that bond for more than you purchased it, you will owe capital gains on the difference. The only way to avoid taxation on the bond is to hold it until maturity at which time you will get your original investment back (no capital gains). This is a whole post by itself.
Okay, now it’s your turn to weigh in. Did this post make sense? Did I miss anything?