How to Decide Between Taxable and Tax Exempt Investments

istock_000002942341_large-4Suppose you are considering two investments. One is tax-exempt and the other is taxable. Which should you choose?

Make the Comparison

The first thing you should determine is the taxable investment’s after-tax yield. If two investments are offering the same rate of return and are of equal quality, you’re better off with the tax-exempt investment. However, taxable investments generally pay a higher rate of return. Thus, you can’t make a fair comparison without considering the taxes you would pay in your tax bracket on the income from the taxable investment.

Here is a simple three-step formula for comparing your after-tax return on a taxable investment with the return on a tax-exempt investment.

Step 1: Subtract your marginal tax rate from 100%. (For example, in a 28% tax bracket, 100% – 28% = 72%.)

Step 2: Multiply the rate of return on the taxable investment by the resulting percentage. (6% hypothetical return ´ 72% = 4.32% after-tax return.)

Step 3: Compare this rate with the rate of return on the tax-exempt investment.

In our example, the investor in a 28% marginal tax bracket would choose the taxable investment paying 6% over a tax-exempt paying less than 4.32%. A tax-exempt investment paying more than 4.32% would be the better deal, assuming it were of equal quality.

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