Taxable vs Tax-Exempt Investments

Did you ever wonder why some investments are tax-exempt? Most people don't wonder about this because tax-exempt bonds have been around for so long. But the distinction between taxable and tax- exempt investments goes back to an 1819 case where the Supreme Court ruled that the federal, state, and local governments do not have the power to tax each other. Thus, federal bonds are exempt from state and local taxes, and municipal bonds -- those issued by states, cities, school districts, and other political subdivisions -- are exempt from federal taxes. In addition, if you buy the bonds issued by the municipality in which you live, your investment is usually exempt from state and local tax, as well as federal tax.

Did you ever wonder why people would prefer a taxable investment over a tax-exempt investment? Generally, if both investments are paying the same rate of return and are of equal quality, you're better off with the tax-exempt investment. But that's rarely the case. Taxable investments usually pay a higher rate of return, and you have to consider your particular tax bracket to determine which investment is better for you.

Here's a simple, two-step formula to help you find your crossover point -- the point where a taxable investment produces the same return after taxes as a tax-exempt return: (1) Subtract your marginal tax rate from 100% and (2) divide your tax-exempt rate by the resulting percentage.

The result is the yield you would have to secure from a fully taxable investment to equal your tax-exempt rate of return. For example, if you are in a 28% marginal federal tax bracket, your crossover point on a tax-exempt investment returning 6.5% is 9%. The calculation: 100% - 28% = 72%; 6.5% ö by 72% = 9%. If the investment is free from state and/or local taxes as well, that tax rate should also be taken into account.

Did you ever wonder why those who invest in municipal bonds take different approaches? The approach an investor takes will probably depend on his or her investment needs or desires. For example, if you want to invest long-term, but you want to protect yourself against rising interest rates, you might use the so-called "ladder approach." With $250,000 to invest, for instance, you might stagger your bond purchases so that $25,000 of bonds mature each year. Then, as they mature, you can reinvest the proceeds for another ten years.

If, on the other hand, you want long-term growth with some liquidity, you might use the "barbell" approach. Again, assuming a $250,000 investment, you might put $175,000 in ten- year bonds for growth and the remaining $75,000 in one-year bonds for liquidity. Once more, your particular approach will depend on your particular circumstances. Did you ever wonder about investments? Most likely, you have, especially as you adapt to changes in your life and as you plan for the future. If we can be of assistance in that planning, please give us a call. As professional investment managers, we can help you deal not only with the questions, but with the answers as well.

ENB Associates Inc. is a wholly owned subsidiary of Evans National Bank. Securities are offered by O'Keefe Shaw & Co., Inc. Member NASD, and SIPC. Products purchased through O'Keefe Shaw may lose value, are not deposits with obligations of, or guaranteed by Evans National Bank or affiliates and are not insured by the FDIC.