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Trim Your Taxes With Treasuries

Banks tempt investors with high rates on CDs. But if you live in a state with high income taxes, you may be better off with good old-fashioned Treasury securities for your short-term savings.

In response to my article on bank CDs, a number of readers commented that despite higher CD rates, they found better returns from investments in Treasury bills and notes. Without exception, each of the people who responded live in places with high state income taxes. Because many people live in such states -- including California, New Jersey, New York, and North Carolina -- it makes sense to take a second look.

Tax breaks for Treasuries
What makes the decision between CDs and Treasuries more complicated for residents of high-tax states is that Treasuries get a special tax break. States aren't allowed to tax income from federal debt, which includes Treasury bills, notes, and bonds. On the other hand, most states tax interest on bank CDs. So if you're in a high state income tax bracket, even a higher-rate CD could leave you with less money after you take taxes into account.

For instance, look at an example based on the rates from the previous article. If you live in California, your tax rate could be as much as 9.3%. You'll pay state income tax on bank CD interest, but not on interest from Treasuries. As a result, even though the CD rates are uniformly higher, Treasuries provide a better return after state income tax for some of the shorter maturities:

Term

Treasury Rate

CD Rate

CD Rate after
9.3% state income tax

6 months

5.03%

5.41%

4.91%

1 year

4.90%

5.41%

4.91%

2 year

4.63%

5.30%

4.81%

3 year

4.55%

5.20%

4.72%

5 year

4.54%

5.35%

4.85%

Mix in munis?
You'll notice that in comparing bank CDs and Treasuries, you're still dealing with investments that incur federal tax liability. For some investors, short-term municipal bonds will provide better after-tax yields than bank CDs, Treasuries, or other types of taxable debt securities.

The problem with municipal bonds is that they're generally much harder to purchase. All you have to do to buy a CD is go to your bank or fill out paperwork by mail or online. To buy Treasuries, all you need is a Treasury Direct account. Municipal bonds, on the other hand, require both a brokerage account and a working knowledge of the muni-bond market. Dominated by big players like Goldman Sachs (NYSE: GS  ) , Morgan Stanley (NYSE: MS  ) , and Lehman Brothers (NYSE: LEH  ) , the muni-bond market has been plagued by concerns over alleged wrongdoing. Bond purchases often require high minimum investments. For all but the most sophisticated investors, mutual funds are the best way to get access to municipal bonds, but their expenses can make them less competitive than direct offerings from bank or the Treasury, even on an after-tax basis.

The lesson here is that you should always take claims about rates of return with a grain of salt. Until you know the tax implications of a particular investment, you can't make a valid comparison. While high rates will often produce the highest after-tax returns, it's worth a second look to make sure you're not missing out on a better deal.

Related articles:

To learn more about incorporating taxes into your financial plan, take a look at the Fool's Tax Center. You'll find information you can use to keep your taxes low and make the most of tax incentives for investors.

Fool contributor Dan Caplinger owns both Treasuries and bank CDs. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy is never taxing.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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