April 1999 - Article 2

Comparing Tax-Exempt and Taxable Investment Yields

What taxable yield would you have to get to exceed a 7% tax-free return?

A fairly straight-forward formula can be applied to come up with comparative yields if you know your tax bracket.

Here's how it works:
Assume you are in the 31% federal income tax bracket (so an additional dollar of taxable income would cost you 31 cents in additional tax). You have learned of an investment opportunity which offers a 7% tax-exempt yield. You want to know how this compares favorably with your taxable investment opportunities.
(1) Subtract your tax bracket from 1. This equals 0.69 (1 minus 0.31).
(2) Divide the tax-exempt yield (7%) by the figure arrived at above (.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. Simply subtract the taxable percentage from the taxable yield. That is, 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 the federal income tax 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. Thus, for a taxpayer in the 31% federal bracket, a 6% state income tax is only effectively 4.14% (6 × 0.69) because each dollar taxed by the state saves 31 cents in federal taxes.

There may 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, give us a call and we will run some more exact numbers for you.

Please call us if you would like to discuss the details of your particular circumstances.

Veres & Company
Certified Public Accountants
Freedom Square Office Park
4401 Rockside Road, Suite 406
Independence, Ohio 44131
(216) 524-8422
Fax (216) 524-2624
e-mail: staff@veres.com