What Tax Rate Is Applicable to Your Investment Decision?

tax-rateThere is disagreement as to which income tax rate should be applied when deciding whether to purchase, for instance, a municipal bond or a corporate bond. Some people say that you should use the tax rate for your last dollar of taxable income―the highest tax rate applicable to you. Other people say you should use your overall average tax rate. The former is often, but not always, true. The latter is never true. The correct answer depends upon the situation.

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The best way to see this is through examples. Below is a sample investor.

Notice that some of the investments produce taxable income and some produce tax-free income. Now, let us look at some related situations.

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Example A

Let us pretend, first, that one of the tax-free municipal bonds matures; and the investor is deciding whether to buy another tax-free municipal bond or make a taxable fixed-income investment instead. The correct tax rate to apply is the tax rate beginning immediately after the last dollar of taxable income, unless making a taxable fixed-income investment would lead to the investor crossing into a higher tax bracket. If the investor would cross into a higher tax bracket, the correct tax rate to apply is a blend of the tax rate beginning immediately after the last dollar of taxable income and the higher tax bracket rate.

If the highest tax rate applicable to the investor is 25% and making a taxable fixed-income investment would not cross the investor into a higher tax bracket, 25% is applicable. If the highest tax rate applicable to the investor is 25% and making a taxable fixed-income investment would cross the investor into the 28% tax bracket, some figure between 25% and 28% is applicable. The correct figure depends on how much of the additional taxable interest would be taxable at 25% and how much would be taxable at 28% if the investor made the taxable fixed-income investment versus the municipal bond investment.

The reason that the above is true is because only part of the investment portfolio is changing. The remainder of the investment portfolio and the Taxable Non-Investment Income will remain the same. The taxes on the remainder of the investment portfolio and the Taxable Non-Investment Income will be the same, regardless of what investment decision is made. The tax implications of the investment decision are limited to what additional taxes the investor will or will not have if they chose investment option A versus investment option B or vise versa. Taxes that will exist regardless of which investment decision is made are irrelevant to the investment decision.

The best way to make the tax adjustment in evaluating the different investment options is to apply the applicable tax rate to the interest rate of the taxable fixed-income investment(s) being considered. If a corporate bond paying 3.25% is being considered and the applicable tax rate is 26.5%, the following math applies.

3.25% * (100% – 26.5%) = 2.39%

Now you have a tax-adjusted corporate bond interest rate (i.e., 2.39%) that you can compare to the interest rate of a tax-free municipal bond that you may invest in instead. (The complete calculations for comparing fixed-income investment options are more complicated than this.)

Example B

Let us pretend, now, that one of taxable bonds matures; and the investor is deciding whether to make another taxable fixed-income investment or buy a tax-free municipal bond instead. The correct tax rate to apply is the tax rate of the last dollar of taxable income, unless buying a tax-free municipal bond would lead to the investor crossing into a lower tax bracket. If the investor would cross into a lower tax bracket, the correct tax rate to apply is a blend of the tax rate of the last dollar of taxable income and the lower tax bracket rate.

If the highest tax rate applicable to the investor is 25% and buying a municipal bond would not cross the investor into a lower tax bracket, 25% is applicable. If the highest tax rate applicable to the investor is 25% and buying a municipal bond would cross the investor into the 15% tax bracket, some figure between 15% and 25% is applicable. The correct figure depends on how much of the additional taxable interest would be taxable at 15% and how much would be taxable at 25% if the investor made the taxable fixed-income investment versus the municipal bond investment.

Example C

Let us pretend, this time, that the investor is questioning whether they should have any taxable fixed-income investments at all (less the savings account). The correct tax rate to apply is, likely, the tax rate beginning immediately after the last dollar of Taxable Non-Investment Income, applicable Long-Term Stock Investments via Index ETFs and/or Individual Stocks income, if any, and Savings Account income combined. (There may not be any applicable stocks income because there may be only long-term capital gains and/or qualified dividends, both of which are taxed at special rates, for the stocks.) The correct tax rate to apply is higher if a taxable investment cannot be made without crossing into a higher tax bracket.

Conclusion

We all know how income taxes work. Your first dollar of taxable income is taxed at 0%. The more taxable income you accumulate, the higher the applicable tax rate is. You can make the thinking process I described above easier by simply picturing where in the progressive tax scale the investment decision falls. Below is a sample picture.

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To do this process correctly, you need an understanding of what your taxes will be like for the current year and subsequent years. Hopefully, this understanding is relatively easy to achieve because your taxes will be similar to your taxes for preceding years. Also, complications like the alternative minimum tax are not considered here.

From a tax perspective, you should employ what-if scenarios in making investment decisions. You should ask: What will my taxes be on this particular investment if I buy a taxable versus a tax-free vehicle? The other taxes you will pay are irrelevant to the investment decision. They will exist in equal proportion whether you buy a taxable or a tax-free vehicle.

(Comments are desired, but I do not guarantee their publication. If your comment[s] indicates that you did not read and genuinely consider the all of the article’s contents, I may remove it from the article. Also, you do not need to agree; but do not be derogatory. The comment section is meant for legitimate questions or concerns and well-intended discussion.)

 

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Comments

  1. Not sure says

    Never is a word those in the financial world learn to stay away from. I can easily put together a situation that could make your “never” statement look silly due to changing portfolio allocations, dividend cuts, layoffs, and/or changing tax situations (doesn’t have to be all of the above). To use the word “never” in the context of something having to do with our complex tax code and in the context of being able to accurately predict future income, future portfolio allocations, and tax brackets (which you need to be able to predict in order to say “never” in this case) is not a wise decision.

    • Kurt Shrout says

      Please read the article again and think about it some more. You cannot “easily put together a situation that (would) make (my) ‘never’ statement look silly”. My “never” statement is, essentially, correct. “Changing portfolio allocations, dividend cuts, layoffs, and/or changing tax situations” only effect where in the progressive tax scale the investment decision falls. They do not make the overall average tax rate applicable. If, after rereading the article and thinking it some more, you still do not believe this, attempt to actually construct a situation where the overall average tax rate is applicable. You should find that the only way it is possible is for the person to have no non-investment sources of taxable income and for them to be evaluating making a single investment while having no other taxable investments (including not a single penny of savings or checking account interest). This possibility was not worth mentioning in the article.

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