Taxable vs. Tax-Exempt Investments
Tax-exempt investment should cut tax bills, not earning power. Typically, tax-exempt choices offer lower returns than taxable peers, recouping the difference through tax savings.To compare taxable and exempt investment returns, calculate the "tax-equivalent yield." For example, comparing a taxable return of 7.5 percent with a tax-exempt yield of 5 percent.
Start by converting your tax bracket to a decimal and subtracting it from one. (Example: The 36 percent bracket becomes 0.36 which, subtracted from 1.0, leaves 0.64.)
Divide the tax-free yield by the remainder to get the tax-equivalent yield. (Example: 5.0 percent divided by 0.64 equals 7.8125 percent, beating the yield of a taxable investment returning 7.5 percent.)