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.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. The information contained in this newsletter was not intended or written to be used and cannot be used for the purpose of (1) avoiding tax-related penalties prescribed by the Internal Revenue Code or (2) promoting or marketing any tax-related matter addressed herein. © 2014