First of all, can you compare a taxable yield to a tax-free yield, or is that like comparing apples to oranges? You can, but you must establish a common bottom line so you can compare them. What you are looking for is the equivalent taxable yield. You get interest but you must pay taxes on that interest. Bonds give you a return that is not taxable. Which is better? The question may sound simple, but you need to know how to figure out which is truly better for you. Here's a formula to help you:
(1 Minus Tax Rate) = Equivalent Taxable Yield
You have a yield on a bond paying you six percent tax free, and you are in a 36 percent federal tax bracket. What taxable rate would it take to equal the six percent you are receiving on your bonds? Let's begin. Six percent is the tax-exempt yield. One minus the tax rate (1 -.36) is .64. We divide 6% by .64 to give us 9.4%, the taxable yield that you would have to earn to equal a six percent tax-free yield. Interesting isn't it?
Well it's not quite that simple. Unfortunately, a lot of us live in states that have an income tax that we must pay in addition to federal taxes. Since local taxes are deductible from federal taxes, you can't just simply add the tax rates together. The formula for figuring the local effective tax rate is:
Local Tax Rate x (1 Minus Federal Tax Rate)= Effective Local Tax Rate
Let's assume a local rate of five percent (that's the rate in Maryland). So we have 5% x (1-.36)= 3.2%, the effective local tax rate. Now you must add that to your federal tax rate and run the formula again: 3.2% + 36% = 39.2%. You round it off to 39 percent to keep the figures easy to work with.
Now let's go back to our original formula:
(1 Minus Tax Rate)= Equivalent Taxable Yield
The tax-exempt yield was 6% divided by (1 minus .39)=9.8%. That's what you would have to earn after taxes to equal a six percent tax-free return.
It still gets a little more difficult if you live in an area that has a county or city tax. No problem, just add those to the formula when you are figuring effective local taxes. Once you do this a few times it gets easier, so don't panic.
Obviously, the higher the tax bracket, the more attractive tax-free investments look, but before you dump your entire portfolio, make sure this is the best move for you. Equivalent yields are only one aspect of an investment portfolio. I would advise you to talk to your broker and your accountant before making any changes. As they say, a little knowledge can be a dangerous thing unless you put it to a good use.
Your comments and inquiries may be directed to:
Stanley Greenfield, RHU
125 Crofton Hill Lane
Rockville, Maryland 20850
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