As interest rates have risen, investors have been attracted to bank certificates of deposits and short-term U.S. Treasury securities because they have been able to take very little risk to receive yields of 5% or more. But interest payments from bank accounts and from Treasury securities are taxed in different ways, and your after-tax yields may be paltry. With recent changes in the bond market, as longer-term yields have been shooting up, this is a good time for income-seekers to do some calculations to understand which investments offer the highest after-tax yields.
For starters, let’s summarize tax implications for U.S. residents:
Interest you receive on bank CDs is subject to federal income taxes, as well as state and local income taxes.
Interest you receive on U.S. Treasury bills, notes or bonds is subject to federal income taxes but exempt from state and local income taxes.
Most municipal bonds (those issued by state and local governments) are exempt from federal income taxes. They are also exempt from state and local income taxes if issued within the state in which you reside. Investors need to be careful when selecting individual municipal bonds because some of them are actually taxable.
If you own tax-exempt municipal bonds, the income is still reported to the Internal Revenue Service and if you are a Social Security recipient, is included in the total income calculation to determine how much of your Social Security income is taxed. Tax-exempt income is also used to calculate Medicare premiums. Charles Schwab has a summary of seven municipal bond tax traps.
Income seekers need to consider risk, as well as taxes. Bank CDs are insured by the FDIC with an ordinary limit of $250,000 within one bank. However, your actual insurance coverage might be considerably higher if you have joint accounts or accounts in the name of a business or of a trust. The insurance picture can be complicated, and you can learn more by reading the FDIC’s guide to Your Insured Deposits.
U.S. Treasury securities are considered to be the safest bonds. Municipal bonds issued by state and local governments have more risk, but defaults are rare. Most of these securities are rated by Standard & Poor’s, Moody’s or Fitch. AAA ratings from S&P or Fitch (or Aaa ratings from Moody’s), are the highest, while ratings of BBB- or higher from S&P or Fitch (or Baa3 from Moody’s) are considered the lowest for “investment-grade” debt securities. Fidelity breaks down the credit agencies’ ratings hierarchy.
Next we will calculate taxable equivalent yields for comparison, first considering only federal income taxes and then bringing in state income taxes, using New York and California as examples.
Federal tax brackets and taxable equivalent yields
Before calculating taxable equivalent yields, let’s summarize the tax brackets. For federal income taxes you might be subject to the Alternative Minimum Tax, which we will not cover in this article.
These are the marginal federal tax brackets for 2023. The Internal Revenue Service is expected to announce revised 2024 brackets later in October. Keep in mind these income levels are after standard or itemized deductions:
Graduated tax rate
Income over (individual)
Income over (married, filing jointly)
12%
$11,000
$22,000
22%
$44,725
$89,450
24%
$95,375
$190,750
32%
$182,100
$364,200
35%
$231,250
$462,500
37%
$578,125
$693,750
Source: Internal Revenue Service
To calculate a taxable-equivalent yield, divide your tax-exempt yield by 1 less your highest graduated tax rate.
If you are subject to state or local income taxes, you will have to include those rates in your calculation. But to begin, let’s keep it simple by imagining you live in Texas, Florida or another state without an income tax.
The $34 billion iShares National Muni Bond ETF
quotes a 30-day SEC yield of 3.87%. This is a standard yield calculation that is useful for comparisons. It annualizes the fund’s current dividend payout. The 30-day yield is net of expenses, which for this fund come to 0.07% of average assets annually. The fund’s effective duration is 6.61 years. This is a risk measure that takes bonds’ maturity dates into account. Typically, the longer the maturity, the more a bond’s market value will fluctuate as interest rates move. This duration of 6.61 means investors can expect the share price to fall by 6.6% if interest rates rise by 1% and vice versa.
All four exchange-traded funds mentioned in this article pay monthly dividends.
For a married investor whose annual taxable income is between $89,450 and $190,750, we calculate a taxable-equivalent yield by dividing 3.87% by one less the tax rate of 22%. The tax-exempt yield of 3.87% divided by 0.78 gives us a taxable-equivalent yield of 4.96%.
The SPDR Portfolio Intermediate Term Treasury ETF
has a 30-day SEC yield of 4.52%, after expenses of 0.03%. This fund has $4.1 billion in assets and an option-adjusted duration of five years, meaning it is likely to be less volatile than MUB. But for our first example, the taxable-equivalent yield of 4.96% means the investors is better off with MUB’s tax-exempt yield of 3.87%.
Here is a list of taxable equivalent yields for MUB, again based on the quoted 30-day yield of 3.87%:
Tax-exempt yield for MUB
Graduated tax rate
Taxable-equivalent yield
3.87%
12%
4.40%
3.87%
22%
4.96%
3.87%
24%
5.09%
3.87%
32%
5.69%
3.87%
35%
5.95%
3.87%
37%
6.14%
In this example, we have used intermediate-term funds for comparison, at a time when the intermediate interest rates are close to, or even exceed, longer-term rates. You can make your own comparisons looking at funds with longer maturities. If the current movement toward a normalization of the yield curve continues, with long-date bonds paying more than short-term securities, and you are willing to tolerate additional price volatility risk, you can pursue higher yields by going longer.
Factoring-in state income taxes
Before looking at taxable equivalent yields for two high-tax states, keep in mind that income from U.S. Treasury securities is exempt from state and local taxes. Our married investor in the first example would be subject to a state income tax of 9.3% in California. So the above-mentioned SPDR Portfolio Intermediate Term Treasury ETF’s 30-day yield of 4.52% can be adjusted to a state-taxable equivalent yield of 4.52% divided by 1 less 0.093, or 4.98%.
A California breakdown
Here are the latest available California income tax brackets compiled by NerdWallet:
California state income-tax rate
Taxable income bracket (individual)
Taxable income bracket (married, filing jointly)
1.0%
$0 to $10,099
$0 to $20,198
2.0%
$10,100 to $23,942
$20,199 to $47,884
4.0%
$23,943 to $37,788
$47,885 to $75,576
6.0%
$37,789 to $52,455
$75,577 to $104,910
8.0%
$52,456 to 66,295
$104,911 to $132,590
9.3%
$66,296 to $338,639
$132,591 to $677,278
10.3%
$338,640 to $406,364
$677,279 to $812,728
11.3%
$406,365 to $677,275
$812,729 to $1,354,550
12.3%
Over $677,275
Over $1,354,550
13.3%
If subject to 1% surcharge
If subject to 1% surcharge
Source: FactSet
The highest bracket with the 1% surcharge is for California residents whose annual income exceeds $1,000,000.
For the following taxable-equivalent yield calculations we will leave aside the 1.5% city income tax for San Francisco residents.
The iShares California Muni Bond ETF
has $2.2 billion in assets and quotes a 30-day SEC yield of 3.49%, after expenses of 0.25%. Its modified duration is 6.11 years.
Here are estimated taxable equivalents for California residents for CFM and for SPTI, followed by important explanations:
Tax exempt Yield for CMF
Yield for SPTI, exempt from state taxes
California tax rate
Approximate federal tax rate for this California bracket
CMF taxable-equivalent yield
SPTI fully taxable-equivalent yield
3.49%
4.52%
1.0%
0%
3.53%
4.57%
3.49%
4.52%
2.0%
12%
4.06%
4.61%
3.49%
4.52%
4.0%
12%
4.15%
4.71%
3.49%
4.52%
6.0%
22%
4.85%
4.81%
3.49%
4.52%
8.0%
22%
4.99%
4.91%
3.49%
4.52%
9.3%
35%
6.27%
4.98%
3.49%
4.52%
10.3%
35%
6.38%
5.04%
3.49%
4.52%
11.3%
35%
6.50%
5.10%
3.49%
4.52%
12.3%
35%
6.62%
5.15%
3.49%
4.52%
13.3%
35%
6.75%
5.21%
The federal tax brackets are approximations, because the state and federal bracket ranges don’t match. For example, California’s individual income range for its 9.3% income tax bracket is from $66,296 to $338,639. That range is so wide that it encompasses four federal tax brackets. For our estimates, we used the 32% federal bracket for this range.
If you are considering tax-exempt investments, you should make more precise calculations using your taxable 2022 income and applying the state and federal tax brackets.
If we compare fully taxable equivalent yields for the iShares California Muni Bond ETF
and the SPDR Portfolio Intermediate Term Treasury ETF
,
and consider that you can find CD rates of 5.5% pretty easily, it appears that for a California resident, CMF is a good deal if you are at least in the 9.3% state tax bracket.
The above discussion only encompasses taxable equivalent yields. But your timing and the direction of the economy also need to be considered. If the Federal Reserve were to change course during an economic slowdown, interest rates would decline quickly, which would lift bond prices and make CD much lower for people looking to renew them. So bonds or bond funds may be compelling for long-term investors.
Taxable equivalent yields for New Yorkers
For New York, our taxable equivalent calculations will be more broad to add information for residents of New York City, who pay high local income taxes. The city of Yonkers also has its own income tax but we’re leaving that one aside.
Here are the latest available New York state income tax brackets compiled by NerdWallet.
NY state income-tax rate
Taxable income bracket (Individual)
Taxable income bracket (married, filing jointly)
5.00%
$0 to $8,500
$0 to $17,150
4.50%
$8,501 to $11,700
$17,151 to $23,600
5.25%
$11,701 to $13,900
$23,601 to $27,900
5.85%
$13,901 to $80,650
$27,901 to $161,550
6.25%
$80,651 to $215,400
$161,551 to $323,200
6.85%
$215,401 to $1,077,550
$323,201 to $2,155,350
9.65%
$1,077,551 to $5,000,000
$2,155,351 to $5,000,000
10.30%
$5,000,001 to $25,000,000
$5,000,001 to $25,000,000
10.90%
Over $25,000,000
Over $25,000,000
Source: NerdWallet
And here are the latest available New York City income-tax rates from the 2022 state income tax instructions.:
NYC income-tax rate
Taxable income bracket (individual)
Taxable income bracket (married, filing jointly)
3.078%
$0 to $12,000
$0 to $21,600
3.762%
$12,001 to $25,000
$21,60 to $25,000
3.819%
$25,001 to $50,000
$45,001 to $90,000
3.876%
Over $50,000
Over $90,000
Source: New York state tax instructions for 2022.
The iShares New York Muni Bond ETF
has $636 million in assets and quotes a 30-day SEC yield of 3.75%, after expenses of 0.25%. Its effective duration is 6.61 years.
To keep the tables from being too wide, the taxable equivalents for New York are presented twice, first for residents of the state who live outside New York City, and then for NYC residents.
NY State:
Tax exempt yield for NYF
Yield for SPTI yield, exempt from state taxes
New York state tax rate
Approximate federal tax rate for this New York state bracket
NYF taxable equivalent for NY state resident outside NYC
SPTI fully taxable equivalent for NY state resident outside NYC
3.75%
4.52%
5.00%
0%
3.95%
4.76%
3.75%
4.52%
4.50%
12%
4.49%
4.73%
3.75%
4.52%
5.25%
12%
4.53%
4.77%
3.75%
4.52%
5.85%
24%
5.35%
4.80%
3.75%
4.52%
6.25%
32%
6.07%
4.82%
3.75%
4.52%
6.85%
35%
6.45%
4.85%
3.75%
4.52%
9.65%
37%
7.03%
5.00%
3.75%
4.52%
10.30%
37%
7.12%
5.04%
3.75%
4.52%
10.90%
37%
7.20%
5.07%
NYC:
Tax exempt yield NYF
Yield for SPTI, exempt from state and city taxes
New York state tax rate
Approximate NYC tax rate for this New York state bracket
Approximate federal tax rate for this New York state bracket
NYF taxable equivalent for NYC resident
SPTI fully taxable equivalent for NYC resident
3.75%
4.52%
5.00%
3.078%
0%
4.08%
4.92%
3.75%
4.52%
4.50%
3.078%
12%
4.66%
4.89%
3.75%
4.52%
5.25%
3.762%
12%
4.75%
4.97%
3.75%
4.52%
5.85%
3.819%
24%
5.65%
5.00%
3.75%
4.52%
6.25%
3.876%
32%
6.48%
5.03%
3.75%
4.52%
6.85%
3.876%
35%
6.91%
5.06%
3.75%
4.52%
9.65%
3.876%
37%
7.58%
5.23%
3.75%
4.52%
10.30%
3.876%
37%
7.68%
5.27%
3.75%
4.52%
10.90%
3.876%
37%
7.78%
5.30%
Once again we had to estimate the federal brackets for some of the state brackets and also estimate some of the city brackets, because the three bracket sets don’t match. You can and should use your own information to calculate the most accurate taxable equivalent yields.
Conclusion
Keep in mind that state, federal tax bracket ranges are likely to change soon for 2024. There are also more tax brackets than we have covered in the article, with differences, depending on the government entity, for head of household or for married couples filing individually.
As discussed at the bottom of the California section of this article, the highest taxable yield may not be the only important factor for a long-term investor to consider. An eventual decline in long-term interest rates will leave savers with maturing CDs in a difficult situation when they face lower renewal rates and bond prices already driven up by the lower rates. This is why a diversified approach by asset class and by maturity or duration may be best.
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