As you choose a type of investment to make, your options will fall in either the taxable or tax-free bucket. With taxable investments, any income is subject to federal and state taxes. An exception would be US obligations, like Treasury Bonds, whose income is tax exempt at the state level. With tax-free investments, like municipal obligations, the income is exempt from federal tax and is exempt from state tax if the obligations are from that state. When deciding whether it is more advantageous to invest in taxable or tax-free investments, there are a number of items to consider, of which I’ll touch on a few.
First, you should consider the rate of return of the investments and the tax rate at which they’ll be taxed. Below is a chart which shows specifically the federal tax exempt yield and what the equivalent federal taxable yield would be based on different tax rates. It also takes into account if the 3.8% net investment income tax applies (Information on Net Investment Income Tax).
Another consideration for exempt income is whether or not it’s exempt for both regular federal tax and alternative minimum tax (AMT). Income from certain Private Activity Bonds are tax exempt from regular taxes but are taxable under the AMT. Private Activity Bonds are issued by or on behalf of local or state governments for the purpose of financing projects of a private entity or user. If you’re paying AMT and have tax free investments, you should avoid private activity bonds.
One final item is that it may be advantageous to generate taxable investment income if there is investment interest expense. The interest expense that is incurred can be deducted to offset the income.
This is a brief overview of some of the particulars of taxable versus tax-free investments. If you would like additional information, please reach out to your MKS&H tax consultant.
Article contributed by Tony Dulo, MKS&H Tax Manager
About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.