When it comes to earning interest on your investment dollars, the important thing is not how much you make, but how much you get to keep. The Internal Revenue Service considers all income that is not specifically exempted by law from taxation to be taxable income. That includes most, but not all, types of interest payments. For example, while the interest on corporate bonds is taxable income, the interest on qualifying municipal bonds is free from federal income taxes. You need to know the after-tax yield before you can determine which investment is best for you.
Famous physicist Albert Einstein once commented, “The hardest thing in the world to understand is the income tax.” The U.S. tax code has only grown more complex since Einstein's day, and taxable interest is just one more thing that complicates the issue. The big question is whether or not your interest payments are taxable. The IRS considers interest that you receive or that is made available to you through a credit to your account, which you can withdraw without penalty, to be taxable income, with one notable exception. Interest on most bonds that are issued by a state or state subdivision, the District of Columbia, or a U.S. possession and are used to finance government are not subject to federal income taxes. The interest on these bonds may also be exempt from state and local taxation to local citizens.
Investments that pay taxable interest include your local bank savings account, certificates of deposit and corporate bonds. The level of risk associated with the investment plays an important role in determining the amount of interest the investment must pay. For example, a Federal Deposit Insurance Corporation-insured passbook saving account is one of the safest places to put your money, so these accounts pay a minimal rate of interest. A corporate bond that is rated lower than BBB by Standard and Poor's is considered a high-risk, or junk bond. These bonds must pay a much higher interest rate to compensate for the risk.
Since the federal government prohibits states from taxing federal government bonds, it seems only fair that the federal government should not tax state-issued municipal bonds. The legal and political tradition of the U.S. government since the passage of the 16th Amendment is that taxing municipal bond interest would place an undue burden state governments, so investors get a tax break by investing in municipal bonds. Because the interest is tax-free, the interest rate paid on municipal bonds is usually lower than comparable-quality corporate bonds.
Whether you are better off investing in securities that pay taxable or non-taxable interest depends on your tax bracket. The higher your tax bracket, the greater the benefit you will derive from investing in securities that pay non-taxable interest. For simplicity, use a standard principal amount to figure your yield, such as $10,000, regardless of how much money you actually have to invest. Multiply your principal amount by the stated interest rate to get your yield. Multiply the result by your current tax rate to determine your tax obligation, then subtract that amount from your yield to get your after-tax yield. Divide your after-tax yield by the original principal amount to determine your tax-equivalent rate. For example: $10,000 (principal amount) X .06 (stated interest rate) = $600 (yield). $600 X .28 (tax rate) = $168 (tax obligation). $600 – $168 = $432 (after-tax yield). $432 / $10,000 = .0432 (tax-equivalent rate). In this example, a taxpayer who is in the 28 percent tax bracket would need to find a taxable bond that paid at least 6 percent interest to match the yield on a non-taxable bond that paid 4.32 percent interest.
- Fidelity: Tax Exempt Investing
- Internal Revenue Service: What Is Taxable and Nontaxable Income?
- Treasury Direct: EE/E Savings Bonds
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- Internal Revenue Service: Topic 403 -- Interest Received
- Morgan Stanley Smith Barney: Tax-Free Municipal Bonds -- Frequently Asked Questions
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