Calculate Taxable Equivalent Yield
There are plenty of investment vehicles out there that will provide income that is free from income tax and so it’s important to compare apples to apples when making investment decisions. For example, the other day I was talking to Nickel about municipal bonds when he started throwing out taxable equivalent yield numbers at me. See, with municipal bonds, the earnings you receive are free from federal and state taxes, if you live in the state in which the bond is issued. So, if you’re like me and you see a municipal bond with a yield of 3.5%, is it better or worse than a CD throwing off 4.9%? That all depends on your tax bracket.
The equation is:
If the investment is free from only Federal income taxes, then your marginal tax rate is your federal marginal tax bracket. If the investment is free from both Federal and state, then sum up to the two percentages and that’s your marginal tax rate. If it’s free only from state, then your state rate is your tax rate. So, if you’re in the 10% federal income tax bracket and have a 5% income tax, first you subtract 0.15 from 1.00 and then divide .035 by that value (you should get 0.0411, or 4.11%).
Maryland income tax is essentially a flat 5%, so putting that on top of whatever Federal rate you have and your actual yield, for comparison purposes against taxable investments, is thus:
| Marginal Rate | Current Yield | Actual Yield | Difference |
|---|---|---|---|
| 10% | 3.5% | 4.11% | +0.61% |
| 15% | 3.5% | 4.38% | +0.88% |
| 25% | 3.5% | 5.00% | +1.50% |
| 28% | 3.5% | 5.22% | +1.77% |
| 33% | 3.5% | 5.65% | +2.15% |
| 35% | 3.5% | 5.83% | +2.33% |
If you’re in the 28% bracket and have a 5% state income tax, a 3.5% tax free yield is the equivalent of a 5.22% taxable yield!
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9 Comments - Share Your Thoughts
I live in a state without income taxes (thank Xenu!), but I always thought that states with income tax were able to deduct those taxes from federal income taxes. So wouldn’t you instead only use the federal income tax rate, or are you not able to deduct all of your state income tax from the federal income tax? Just curious.
That is true if you itemize your deductions, I just took the easy route and assumed you couldn’t deduct it, but it’s an excellent point.
Investopedia has a slightly different explanation of the calculation of the marginal tax rate.
R(te) = R(tf) / (1 – [tF + tS(1 – tF])
Where:
tF = the marginal federal tax rate of the investor;
tS = the marginal state tax rate of the investor
Say everything is still the same as the above example, except that the muni offers you double tax exemption and that you have also a 10% state income tax rate:
R(te) = 0.05 / (1 – [0.25 + 0.10(1 – 0.25])
R(te) = 0.074
From http://www.investopedia.com/articles/04/072804.asp
I didn’t know you can deduct your state taxes towards your federal taxes! You learn something every day!!!! I better do my itemized deductions this year and see if I will come out ahead.
[...] into all the giveaways on this site!I just found out today from a comment at one of Blueprint’s article that you can deduct state taxes from your federal taxes! I just don’t think this make sense [...]
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Just be aware that you can’t deduct any refund you get from the state because it means it was money the fed couldn’t tax you on. I had to deal with this last year and it came as a bit of a surprise until I understood it all. Since the state is taking out of your gross income, that money isn’t available for the fed to tax, but it should have been. You’ll owe taxes on it when you file though.
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