Effect of Taxation

When you choose between two investments, it is not enough to consider risk and return only; you must also consider the impact of taxes on your decision. What looks like the better deal at first may turn out to be the wrong choice when taxes have been factored into the equation.

Taxes affect investment results directly. For example, pretend you have the choice between two investments: A) a taxable investment paying 6% interest and B) a nontaxable investment offering 5% at the same level of risk. Which one is better? The answer depends on the rate of tax. If the claimant is in the 28% income tax bracket, the tax rate would reduce the net return on the taxable investment to 4.3%. In this example, the nontaxable investment’s return would actually earn more money.

Before taxes, which choice looks better? After taxes, which choice turns out to be better?

Another way to compare A and B is to convert the nontaxable investment’s return to its “taxable equivalent yield.” In this case, earning 4.3% tax-free is mathematically the same as earning 6% taxable for a person in the 28% tax bracket. (Click here for a copy of the equation and more information on taxable equivalent yield.)

Tax rules are complex, and you should seek professional advice before making tax-related decisions. However, the important thing to understand is how big an impact taxes have on potential returns. Be sure to take your ward or client’s tax situation into account when making settlement decisions.