When you are deciding whether to buy tax-exempt municipal bonds or taxable corporate bonds, your tax bracket will tell you whether the lower interest on tax-free bonds makes them a better investment. Here’s a simple way to help you make the right decision.
1. Divide the tax-free yield by the taxable yield.
2. Subtract the result from 100%. This will give you the tax bracket at which each of the investments will result in the same yield.
3. If you are in a higher tax bracket than the bracket you calculated in step two, the tax-free bond will give you a higher after-tax yield. If you are in a lower tax-bracket, the taxable bond will give you a better after-tax yield.
For example, assume that you are considering a tax-free bond that yields 6% and a taxable bond that yields 8%.
1. 6% divided by 8% equals 75%.
2. 100% less 75% equals 25%.
3. If your tax bracket is higher than 25%, the tax-free bond will give you a greater return. If your tax bracket is less than 25%, the taxable bond will give you a better return.