A frequent taxpayer question is whether it is better to invest for tax-free or taxable interest. Generally, taxable interest will provide a greater return, but this may not hold true after taking into account taxes on the income. Therefore, the question is really which provides the greater “after-tax” return.
Making a decision will take on another layer of complexity for higher-income taxpayers beginning in 2013 when the new surtax called the Unearned Income Medicare Contribution Tax is imposed on the unearned income of individuals, estates, and trusts. For individuals, the surtax is 3.8% of the lesser of:
- The taxpayer’s net investment income, or
- The excess of modified adjusted gross income over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others).
“Net” investment income is investment income reduced by allowable investment expenses. Investment income includes income from interest, dividends, annuities, royalties, rents (other than those derived from a trade or business), capital gains (other than those derived from a trade or business), trade or business income that is a passive activity with respect to the taxpayer, and trade or business income with respect to the trading of financial instruments or commodities. For surtax purposes, modified adjusted gross income does not include excluded items, such as interest on tax-exempt bonds, veterans’ benefits, and excluded gains from the sale of a principal residence.
To avoid or minimize this new tax, higher-income taxpayers may wish to alter their investment portfolios to include more of the non-taxable investments described below.
There are basically four types of interest that can be excluded from income, either on the federal return or the state return, and each has its own special considerations.
Municipal Bond Interest
Interest earned from general-purpose obligations of states and local governments, which are issued to finance their operations, are generally tax-exempt for federal purposes. However, the various states usually only exempt interest from bonds issued by the state itself and local governments within the state. Hence, there are two categories of municipal bonds: the tax-free federal and state and the tax-free federal only. Individuals can invest in municipal bonds by directly purchasing a bond or through mutual funds that invest in municipal bonds. Some mutual funds invest in bonds issued only in a particular state, providing residents of that state with income that is excludable on their state returns as well as their federal returns.
For those drawing Social Security, you must also keep in mind that, even though the income itself is tax-free, it is included in the computation used to determine how much of your Social Security income is taxable.
Private Activity Bond Interest
Some municipal bonds, classified as Private Activity Bonds, are tax-free for the purposes of the regular federal tax but may be taxable for the purposes of the federal Alternative Minimum Tax (AMT). If a taxpayer is subject to the AMT, then the interest from these bonds may be taxable to some extent. The actual rate will depend upon your filing status and other AMT income but could be as high as 28% plus any state tax, if applicable.
U.S. Government Bond Interest
Under federal law, direct obligations of the U.S. government cannot be taxed by the states. This includes interest from U.S. savings bonds, U.S. Treasury bills, notes, bonds, or other obligations of the United States. Interest earned from the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC) are not direct obligations of the U.S. government and, therefore, are not excludable from state taxation unless specifically allowed by state law, which is generally not the case. If you reside in a state with no state income tax, U.S. government bond interest provides no tax benefit.
If you do have a state income tax and the investment is tax-free in your state, then it also makes a difference whether or not you itemize your deductions on your federal return. Since having state tax-free income reduces your state tax, which is deductible if you itemize, the reduced state tax, in effect, reduces your itemized deductions and increases your federal tax.
Use the below to determine the tax-exempt interest equivalents for your particular tax bracket, state tax (if applicable), and type of tax-exempt investment. Enter all rates in decimal format. For example, 5.75% would be entered as .0575. Carry all calculated values to at least 4 places after the decimal.
Taxpayer Information
1. Enter the taxable interest rate you wish to compare: _______________
2. Enter your federal tax bracket: _______________
3. Enter your state tax bracket – enter zero if no state tax: _______________
4. If you itemize your federal deduction, enter line 2 times line 3: _______________
Tax-Free Equivalent – State AND Federal Tax-Free:
5. Line 2 plus line 3 minus line 4: _______________
6. If 2013 or later, enter amount from note at bottom: _______________
7. Sum of lines 5 and 6: _______________
8. Multiply line 7 times line 1: _______________
9. Tax-free equivalent (line 1 less line 7): _______________
Tax-Free Equivalent – Federal ONLY Tax-Free:
10. Line 2 minus line 4: _______________
11. If 2013 or later, enter amount from note at bottom: _______________
12. Sum of lines 10 and 11: _______________
13. Multiply line 12 times line 1: _______________
14. Tax-free equivalent (line 1 less line 13): _______________
Tax-Free Equivalent – State ONLY Tax-Free:
15. Line 3 minus line 4: _______________
16. If 2013 or later, enter amount from note at bottom: _______________
17. Sum of lines 15 and 16: _______________
18. Multiply line 17 times line 1: _______________
19. Tax-free equivalent (line 1 less line 18): _______________
Note: Enter 3.8% (.0038) if the taxpayer’s modified adjusted gross income exceeds the following amounts: $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others. Caution: The worksheet computes the tax-free equivalent based upon the last dollar received. For taxpayers with investment income both below and above the thresholds, the tax-free equivalent could be less.
If you have questions related to tax-free investment income or how the new surtax on investment income might impact you, contact the Tax Experts at Henssler Financial.
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
