Dear Clients and Friends:

Someone recently asked me how to compare the yield on a tax-free bond with the yield on a taxable investment. For example, what taxable yield would you have to get to exceed a 7% tax-free return? A fairly straightforward formula can be applied to come up with comparative yields if you know your tax bracket. Here's how it works:

Say you're 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 effectively 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 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 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 with arriving at 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 x 0.69) because each dollar taxed by the state saves 31 cents in federal taxes.

There may be other adjustments to make as well, so if you seek greater precision, give call (315)363-3338 and I'll run some more exact numbers for you.

Very truly yours,

G. William Hatfield
Certified Public Accountant
Certified Financial Planner