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Home > Investing, Taxes > Understanding Investment Income Tax Equivalence

Understanding Investment Income Tax Equivalence

September 2nd, 2011 Leave a comment Go to comments

If you have investments that earn income such as savings accounts, dividend stocks, bonds, and investment funds you will never pay more in taxes than what you earn at your job. In many cases you will pay less. This means that you get to keep more of what you earn. Sometimes, it is useful to compare investments based upon how much you actually keep after taxes.

Investments are taxed in different ways depending on what type it is. You might be surprised how much more you get to keep with your investments versus your income.

When it comes to investing, the primary considerations to determine which ones you pick will come down to the quality and attractiveness of them based upon their fundamentals. If you pick the right investments and buy them at attractive prices, you will make money. And then pay taxes. In the grand scheme of things, this is a good problem to have because it demonstrates that your investment strategy is working.

In this article, I talk about what you need to know to compare income investments on their tax equivalent investment yield, which is a calculated yield for comparison to a target investment. This investment yield will help you compare income investments because it takes into account taxes.

We answer the question: What return would a money market fund have to earn to equal the return of other investments after considering taxes?

Target Equivalent Investment

The natural target to pick is a fully taxable money market fund that you might get at a bank or credit union. After all, this is a typical place that you may have started investing. A few years ago, it was possible to earn 4-5% per year in investments like these, so they made sense to put some of your money there. Today, you are lucky if you earn 1%. We can thank the Federal Reserve for their loose monetary policy for this.

Let’s say you live in New Jersey and earn $80,000 per year. This what your total return would be for a $1,000 money market investment earning 1%:

  • Investment: $1,000.
  • Annual Investment Yield: 1%
  • Investment Return: $10.00 (1% of $1,000)
  • Federal Tax Rate: 28%
  • State Tax Rate: 6%
  • Total Tax Burden: 34%
  • After Tax Return/Yield: $6.60/0.66%

So, as you can see, you aren’t earning much. You earn $10.00 and get to keep $6.60 after taxes.

Welcome To The Investing World

The calculation for stocks, bonds, funds, and other investments can be more complicated than the money market fund above. The good news is that you won’t pay more in taxes than the fully taxable money market investment. Investments are generally in one of the following tax categories:

  1. Taxable – Earnings/Gains taxable at your income tax rate.
  2. Qualified – Earnings/Gains taxable at lower qualified tax rate.
  3. Tax Exempt – Earnings are not taxable, subject to qualification at each government level.
  4. Tax Deferred – Earnings not immediately taxable, but are at a later date.

That last one, tax deferred, may throw you for a curve. What I don’t mean here is tax deferred retirement (401k/IRA) or 529 (college savings) accounts, which by their nature provide tax deferral. This refers to taxable investments that defer taxes through what’s called return of capital. I will talk about this later.

How To Calculate Equivalence

In the case of the full taxable money market fund, we earn 1%/year and get to keep 0.66%. If we found a fully non-taxable investment (say a NJ municipal bond fund), it would only have to earn 0.66% to match the in-the-pocket return. This means that its tax equivalent investment yield is 1%, since this is what would be needed to be earned in the money market fund to match the municipal bond fund.

So, in general, tax advantaged investments are marked up from their nominal investment yield when you compare them to fully taxable investments. The general calculation looks like this:

(qualified investment yield * ( 1 – qualified tax rate)) / ( 1 – fully taxable rate )

This might not make sense initially, because the municipal bond fund didn’t actually earn 1%, it only earned 0.66%. But remember that it’s what you keep in your pocket that matters, since these earned the same amount of money you get to keep, they have equivalent yields.

How Each Investment Stacks Up

The following table calculates the fully taxable equivalent investment yield for different investments. I find this useful to measure the actual income that is earned in each investment. Since the nominal stated income yields do not account for taxes, you can’t use that number as a basis to know exactly how much money you are putting in your pocket and how each investment compares in that regard.

For the purposes of this table, I will use a ‘qualified’ tax rate of 15%, which is the lower Federal tax rate on qualified dividend income (compared to the income rate of 28% in the example above). Also, these yields are calculated as of prices current as of Jan 13, 2011.

Investment Name Investment Symbol Nominal Investment Yield Tax Status Target Equivalent Investment Yield
Money Market Fund N/A 1% Fully Taxable 1%
S&P500 Index Fund SPY 2.00% Mostly qualified 2.31
U.S Treasury I-Savings Bond SPY 3.00% Federal Taxable, State Exempt 3.20%
Realty Income Corp O 5.14% Fully Taxable 5.14%
Philip Morris PM 4.53% Qualified Dividend 5.35%
Enterprise Product Partners EPD 5.42% 75% Tax deferred/25% fully taxable 7.51%
Nuveen NJ Municipal Bond Value Fund NJV 5.50% Federal/NJ Tax Exempt 8.33%
Eaton Vance Muni Bond Fund EIM 8.6% Federal Tax Exempt, State Taxable 11.94%

As you can see here, the money market fund is getting crushed anyway you look at it.

A Word About Tax Deferred Income

As mentioned above, some income is classified as ‘return of capital’, which means that the investment returned some of your money that you initially invested. This might occur if the amount of income was greater than the amount of money the company earned during the year. Since you already paid taxes on this money, no tax is due in the year you receive it.  This does not necessarily imply that the company can’t pay its bills or something is wrong, it is an accounting mechanism.

Taxes would be potentially due when you sell the investment since the ‘return of capital’ lowers your cost basis (widening the potential investment gain). So, return of capital has the same effect as tax deferral. Since this money isn’t taxable in the year you receive it, I treat this as essentially the same as a ‘tax exempt’ investment for the purposes of the calculations in the table above.

Summing It All Up

This whole discussion can be summed up by asking the following question: What return would a money market fund have to earn to equal the return of other investments? This is the good news: investing can offer opportunities to make money as well as pay less in taxes then working at your job.

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