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:
Current Yield ÷ (1.00 – Marginal Tax Rate)
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!