How to Calculate After-Tax Yield

How to Calculate After-Tax Yield

How to Calculate After-Tax Yield

Everyone wants to maximize their rate of return when they invest. After all, who wouldn’t want to earn 8 percent instead of 6 percent on an investment? However, you can’t simply look at the stated return to know how much of your return you’ll get to keep. Instead, you should account for the taxes you’ll pay on your investment, which can differ depending on the type of investment and your income level, to determine your after-tax yield.

Tip

Calculate the after-tax yield by subtracting the tax rate applied to your income from 1 and multiplying the result by your rate of return.

What Is After-Tax Yield?

The after-tax yield, sometimes called the tax equivalent yield, refers to the rate of return on an investment after accounting for the taxes you pay on the earnings. Considering the after-tax yield of different investments is vital to making sure you’re maximizing your returns. First, different people fall into different tax brackets, so the after-tax yield can be different for different people on the same investment. For example, if you are in the 37-percent tax bracket, your after-tax yield for a certificate of deposit will be much lower than the after-tax yield for someone who is in the 10-percent tax bracket.

Second, different investments are taxed at different rates, and some investments are even exempted from For taxes. If you’re expecting to pay 37 percent of an investment in taxes, being able to avoid that tax has a lot more value than if you were only going to pay a 10 percent tax on the income. To determine whether an investment offers the right potential return for you based on the risk that you’re taking on, you need to calculate your after-tax yield.

After-Tax Yield Formula

To calculate your after-tax yield, you need to know both the rate of return on your investment and the tax rate that applies to those profits. First, convert your tax rate that applies to the earnings to a decimal by dividing by 100. Second, subtract the result from 1 to calculate the portion of your earnings that you get to keep after you pay taxes on them. Third, multiply the result by the rate of return on the investment to calculate your after-tax yield.

For example, say that you want to calculate the after-tax rate of return on your certificate of deposit. If your rate of return is 3 percent and the tax rate applied to that interest is 24 percent, start by dividing 24 percent by 100 to get 0.24. Second, subtract 0.24 from 1 to get 0.76 – the portion that you get to keep after accounting for taxes. Finally, multiply 0.76 by your overall rate of return of 3 percent to find your after-tax yield is 2.28 percent.

Ordinary Income Tax Rates

Ordinary income tax rates are the tax rates applied to investment income like interest and short-term capital gains. These are the same rates that are applied to your earned income such as wages, salaries, bonuses and self-employment income. The tax rates are progressive, which means that as you earn more money, the rates applied to additional income increase.

After the Tax Cuts and Jobs Act, the tax rates for the 2018 tax year are lower overall than in previous years. If you’re single, these are the rates you’ll pay:

  • 10 percent on income up to $9,525
  • 12 percent on income between $9,525 and $38,700
  • 22 percent on income between $38,700 and $82,500
  • 24 percent on income between $82,500 and $157,500
  • 32 percent on income between $157,500 and $200,000
  • 35 percent on income between $200,000 and $500,000
  • 37 percent on income exceeding $500,000

For couples filing jointly in 2018, the brackets are wider:

  • 10 percent on income up to $19,050
  • 12 percent on income between $19,050 and $77,400
  • 22 percent on income between $77,400 and $165,000
  • 24 percent on income between $165,000 and $315,000
  •  32 percent on income between $315,000 and $400,000
  •  35 percent on income between $400,000 and $600,000
  •  37 percent on income exceeding $600,000

But married couples filing separately are squeezed a bit at the higher brackets in 2018:

  • 10 percent on income up to $9,525
  • 12 percent on income between $9,525 and $38,700
  • 22 percent on income between $38,700 and $82,500
  • 24 percent on income between $82,500 and $157,500
  • 32 percent on income between $157,500 and $200,000
  • 35 percent on income between $200,000 and $300,000
  • 37 percent on income exceeding $300,000

If you’re head of household, these are the 2018 tax rates for your ordinary income:

  • 10 percent on income up to $13,600
  • 12 percent on income between $13,600 and $51,800
  • 22 percent on income between $51,800 and $82,500
  • 24 percent on income between $82,500 and $157,500
  • 32 percent on income between $157,500 and $200,000
  • 35 percent on income between $200,000 and $500,000
  • 37 percent on income exceeding $500,000

For 2017, the tax rates are noticeably higher than in 2018. If you file your income taxes as single, your ordinary income is taxed as follows:

  • 10 percent on income up to $9,325
  • 15 percent on income between $9,325 and $37,950
  • 25 percent on income between $37,950 and $91,900
  • 28 percent on income between $91,900 and $191,650
  • 33 percent on income between $191,650 and $416,700
  • 35 percent on income between $416,700 and $418,400
  • 39.6 percent on income exceeding $418,400

If you’re married filing jointly, the 2017 income tax rates are applied as follows:

  • 10 percent on income up to $18,650
  • 15 percent on income between $18,650 and $75,900
  • 25 percent on income between $75,900 and $153,100
  • 28 percent on income between $153,100 and $233,350
  • 33 percent on income between $233,350 and $416,700
  • 35 percent on income between $416,700 and $470,700
  • 39.6 percent on income exceeding $470,700

But, if you’re married filing separately, the rates are slightly more compressed at the higher end than the single rates:

  • 10 percent on income up to $9,325
  • 15 percent on income between $9,325 and $37,950
  • 25 percent on income between $37,950 and $76,550
  • 28 percent on income between $76,550 and $116,675
  • 33 percent on income between $116,675 and $208,350
  • 35 percent on income between $208,350 and $235,350
  • 39.6 percent on income exceeding $235,350

If you file as head of household in 2017, these are the rates you’ll pay on ordinary income:

  • 10 percent on income up to $13,350
  • 15 percent on income between $13,350 and $50,800
  • 25 percent on income between $50,800 and $131,200
  • 28 percent on income between $131,200and $212,500
  • 33 percent on income between $212,500 and $416,700
  • 35 percent on income between $416,700 and $444,550
  • 39.6 percent on income exceeding $444,550

Capital Gains Tax Rates

Some investment income is taxed at the lower capital gains tax rates. If you hold an investment for more than one year, the profits from selling it are taxed at the lower long-term capital gains rates instead of the higher ordinary income tax rates. When figuring your applicable capital gains tax rate so that you can accurately calculate your after-tax rate of return, you first add up all of your other income and then determine the rate as if your capital gains income is the last income to be taxed. For example, if you have $70,000 of other income and $10,000 of capital gains, your capital gains are taxed as if the money accounts for your income between $70,000 and $80,000.

For 2018, the capital gains rates depend on your total taxable income. For single filers, the capital gains rates are as follows:

  • 0 percent for income up to $38,600
  • 15 percent for income between $38,600 and $425,800
  • 20 percent for income exceeding $425,800

If you’re married filing jointly, the brackets are larger, which results in more income being taxed at the lower rates:

  • 0 percent for income up to $77,200
  • 15 percent for income between $77,200 and $479,000
  • 20 percent for income exceeding $479,000

But, when you file separately, the brackets are half as large as the married filing jointly brackets:

  • 0 percent for income up to $38,600
  • 15 percent for income between $38,600 and $239,500
  • 20 percent for income exceeding $239,500

For heads of household, the brackets are larger than single filers, but not quite as large as couples filing jointly:

  • 0 percent for income up to $51,700
  • 15 percent for income between $51,700 and $452,400
  • 20 percent for income exceeding $452,400

In 2017, the rules were a bit simpler because the capital gains rate you paid corresponded directly with your ordinary income tax bracket. If the capital gains income would have been taxed at an ordinary income tax rate below 25 percent, the capital gains income was tax-free. If it was taxed at 25 percent or higher, except for income which would have been taxed at the maximum 39.6 percent rate, the capital gains rate was 15 percent. If the income would have been taxed at the maximum 39.6 percent tax rate, the capital gains rate was 20 percent.

For example, say that you have the option to earn a 6 percent return on an investment that generates interest income or a 5 percent return on an investment that generates long-term capital gains income. If your ordinary income tax rate is 32 percent and your capital gains tax rate is 15 percent, the answer isn’t obvious.

First, to calculate the after-tax yield on the interest-bearing investment, divide 32 by 100 to get 0.32. Second, subtract 0.32 from 1 to get 0.68. Third, multiply 0.68 by 6 to find your tax-equivalent yield is 4.08 percent. To calculate the after-tax return on the capital gains-generating investment, divide 15 percent by 100 to get 0.15. Second, subtract 0.15 from 1 to get 0.85. Finally, multiply 5 percent by 0.85 to find your after-tax rate of return is 4.25 percent, which is higher than the interest-bearing investment even though the interest-bearing investment has a higher stated rate of return.

Net Investment Income Tax

If you’re a high-income taxpayer, you may be responsible for paying the additional Net Investment Income Tax on your investment income. For the purposes of this tax, “investment income” includes interest, dividends, capital gains, rental and royalty income, and non-qualified annuities.

The tax is equal to 3.8 percent of the smaller of your net investment income or the amount by which your modified adjusted gross income exceeds the filing threshold for your filing status. The filing thresholds are $250,000 if you’re married filing jointly or a qualifying widow or widower with a child, $125,000 if you’re married filing separately, $200,000 for single filers and heads of household. For example, if your income is $500,000 and you have $200,000 of net capital gains, interest income and dividends, all of your investment income would be hit by the 3.8 percent Net Investment Income Tax. As a result, you need to include the 3.8 percent tax in your tax rate calculation to figure the correct after-tax yield for your investments.

Nontaxable Investment Income

Certain types of income are exempt from either federal or state income taxes. For example, if you purchase federal savings bonds, you won’t pay state income taxes on the bonds. Similarly, if you buy state or municipal bonds, you don’t pay federal income taxes on those bonds, and some states exempt the income from state taxes as well. As a result, a bond that is exempt from some or all taxes could net you a higher rate of return than a taxable investment after you account for the amount of taxes you’ll pay on your profits.

Video of the Day

Brought to you by Sapling
Brought to you by Sapling
 

About the Author

Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."