Many of you are in higher tax brackets and wonder about the advisability of investing in instruments such as tax-free bonds or bond funds. You might not be sure exactly how to compare the yield of the tax-free investment to that of the taxable investment. You might want to know what taxable yield you would have to get to exceed a 7% tax-free return, for example.
A fairly straightforward formula can be applied to come up with comparative yields if you know your tax bracket. Here's how it works:
Say you're in the 31% federal income tax bracket (so an additional dollar of taxable income would cost you $0.31 in additional tax). You have an investment opportunity that offers a 7% tax-exempt yield. You want to know how this compares effectively with your taxable investment opportunities. Here is the formula:
Subtract your tax bracket from 1. This equals 0.69 (1 minus 0.31).
Divide the tax-exempt yield (7% or 0.07) by the figure arrived at above (0.69).
The result is 10.14%. This means that, in your tax bracket, you would need to earn 10.14% on your taxable investment to equal the 7% 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. If you're in the 31% bracket, you'll keep 69% of your income. Thus, a taxable 8% yield translates into an after-tax yield of 5.52% (8 times 0.69).
Note that the above computations only take federal income taxes into consideration. If your income is subject to state or local taxation, which 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.
Be careful in coming up with your effective state income tax rate. Remember that your state income tax is deductible for federal tax purposes. This being the case, for a taxpayer in the 31% federal bracket, a 6% state income tax is only effectively 4.14% (6 times 0.69), because each dollar taxed by the state saves 31 cents in federal taxes.
There might be other adjustments to make as well -- for example, if the increase in your adjusted gross income from the taxable investment has the side effect of reducing other deductions or tax benefits. Accordingly, you can safely use the above approach as a fairly good guideline for comparing investment yields, but if you seek greater precision, you might want to run some actual tax numbers to see if there is any hidden impact. This is where a computerized tax preparation program will come in mighty handy.
This forum and the information provided here should not be relied on as a substitute for independent research to original sources of authority. The Motley Fool does not render legal, accounting, tax, or other professional advice. If legal, tax, or other expert assistance is required, the services of a competent professional should be sought. In other words, if you get audited, don't blame us.