A Publication of WTVP

Are you looking to earn an attractive yield from a fixed-income security? The first step is to determine whether you'd benefit from owning taxable or tax-free debt obligations (bonds). The interest paid on taxable investments, such as U.S. corporate bonds, is subject to federal income taxes. The interest paid on tax-exempt securities, such as municipal bonds, is typically free from federal income tax liability.

So why bother owning taxable securities when you can buy securities that let you keep all of the interest income you earn?

Here's one thing to consider: taxable bonds usually have higher yields than tax-exempt bonds of comparable quality and maturity. Thus, after paying taxes on a taxable issue, you may still have a higher net yield than if you'd bought a comparable tax-exempt security.

To determine whether a taxable or comparable tax-exempt security is right for your personal situation, you need to calculate a tax-exempt security's taxable equivalent yield-the yield you'd need to earn from a taxable investment to equal the yield from a comparable tax-exempt security. Here's how to perform the calculation (assuming the taxpayer doesn't itemize deductions on the federal return and doesn't pay any state income taxes): take the yield on the tax-exempt security and divide it by 1, minus your federal tax bracket. For example, if it yields 3 percent and you pay taxes at a 28 percent rate, divide 3 percent by 0.72 to arrive at your taxable equivalent yield, which, in this case, would be 4.17 percent.

In effect, you'd need to earn at least 4.17 percent from a taxable investment to equal the 3 percent yield you'd earn from a tax-exempt security.

What if you were in the 33 percent bracket? Using the same calculation, you'd have to earn a higher yield from a taxable security (4.48 percent). As you can see, your tax bracket plays an important part in determining whether a taxable or tax-exempt security is the better choice for you. As a general rule, the higher your tax bracket, the more likely you'll benefit from owning tax-exempt securities.

When choosing any fixed-income security, you need to do more than compare yield of various types of taxable and tax-exempt investments to find the one most appropriate for you. For example, you have to decide whether you want to invest in long-, short-, or intermediate-term bonds. Generally, the longer a bond's time to maturity, the higher its yield-but the more likely to fluctuate in value.

You also need to consider each bond's creditworthiness. Rating agencies, such as Standard & Poor's and Moody's Investors Service, review the creditworthiness of the issuing companies of many bonds and rate them.

These are only some of the many important details you should consider when purchasing taxable and tax-exempt securities. For more information, contact your tax advisor or attorney for tax and legal advice and your financial advisor, who can help you make the appropriate investment decisions for your situation. IBI