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What's Best -Tax-Free or Taxable Interest Income?

A frequent taxpayer question is whether it is better to invest for tax-free or taxable interest. Generally, taxable interest will provide the greater return, but this may not hold true after taking into account taxes on the income. Therefore, the question is really which provides the greater "after-tax" return. There are basically four types of interest that can be excluded from income, either on the Federal return or the state return and each has its own special considerations.

Municipal Bond Interest Interest earned from general purpose obligations of states and local governments, which are issued to finance their operations, are generally tax-exempt for Federal purposes. However, the various states usually only exempt interest from bonds issued from the state itself and local governments within the state. Hence, there are two categories of municipal bonds, namely the tax-free Federal and state and the tax-free Federal only. Individuals can invest in municipal bonds by directly purchasing a bond or through mutual funds that invest in municipal bonds. Some mutual funds invest in bonds issued in a particular state only, providing residents of that state with income that is excludible on their state return.

For those drawing social security, you must also keep in mind that even though the income itself is tax-free, it is included in the computation used to determine how much of your social security income is taxable.

Private Activity Bond Interest Some municipal bonds, classified as Private Activity Bonds, are tax-free for purposes of the regular tax, but may be taxable for purposes of the Alternative Minimum Tax (AMT). If a taxpayer is subject to the AMT, then the interest from these bonds may be taxable to some extent. The actual rate will depend upon your filing status and other AMT income, but could be as high as 28% plus any state tax, if applicable.

U.S. Government Bond Interest
By Federal law, direct obligations of the U.S. Government cannot be taxed by the states. This includes interest from U.S. Savings Bonds, U.S. Treasury bills, notes, bonds, or other obligations of the United States. Interest earned from the Federal National Mortgage Association (Fannie Mae), Government National Mortgage Association (Ginnie Mae) and the Federal Home Loan Mortgage (FHLMC) Corporations are not direct obligations of the U.S. Government, and therefore, are not excludable from state taxation unless specifically allowed by state law, and that is generally not the case. If you reside in a state with no state income tax, U.S. Government Bond Interest provides no tax benefit.

If you do have a state tax and the investment is tax-free in your state, then it also makes a difference whether or not you itemize your deductions on your Federal return. Since having state tax-free income reduces your state tax, which is deductible if you itemize, the reduced state tax in effect reduces your itemized deductions and increases your Federal tax.


Use this worksheet to determine the tax-exempt interest equivalents for your particular tax bracket, state tax (if applicable), and type of tax-exempt investment. Enter all rates in decimal format. For example, 5.75% would be entered as .0575. Carry all calculated values to at least 4 places after the decimal.

Taxpayer Information:
1. Enter the taxable interest rate you wish to compare
2. Enter your Federal tax bracket
3. Enter your State tax bracket
(Enter zero if your state has no state income tax)
4. If you itemize your Federal deductions
Multiply line 2 times line 3 and enter the result here

Tax-Free Equivalent - State AND Federal Tax-Free:
5. Line 2 plus line 3 minus line 4
6. Multiply line 5 times line 1
7. Tax-Free Equivalent (line 1 less line 6)

Tax-Free Equivalent - Federal ONLY Tax-Free:
8. Multiply line 2 times line 1
9. Tax-Free Equivalent (line 1 less line 8)

Tax-Free Equivalent - State ONLY Tax-Free:
10. Line 3 minus line 4
11. Multiply line 10 times line 1
12. Tax-Free Equivalent (line 1 less line 11)


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